The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
On September 14, 2010, the IRS issued much-anticipated proposed regulations on the tax classification of "series organizations," a new defined term that includes series LLCs, protected cell companies, and similar segregated arrangements created under commercial law. The proposed regulations are well designed and will be very useful to taxpayers. However, the proposals were not extended to foreign series, except in the case of insurance companies, where some guidance had previously been issued.1 The reason given for this reservation was that "[f]oreign series raise novel Federal income tax issues that continue to be considered and addressed by the IRS and the Treasury Department."2
There are a number of foreign laws providing for series organizations, and many of these are commonly used.3 This commentary speculates on what the novel issues presented by extending the approach of the proposed regulations to foreign series might be. It concludes that all of the potentially difficult issues presented by foreign series organizations would be best resolved by treating foreign series as separate entities, as is done in these proposed regulations, and thus that there is no reason not to extend the proposed regulations to all foreign arrangements.
Brief Summary of the Proposed Regulations
The proposed regulations define three new terms: "series statute," "series organization," and "series." A "series organization" is the "master" entity formed pursuant to a "series statute," such as a series LLC or protected cell company statute. A "series" (which includes, inter alia, a cell) is any segregated group of assets and liabilities established pursuant to the series statute by agreement of the series organization. In the typical case addressed by this commentary, all of the common stock of the series organization will be owned by a single sponsor, and each series will issue nonvoting preferred stock or similar interests, representing the economic rights attributable to that series' segregated group of assets and liabilities, to one or more third parties referred to herein as owners. Each series may have different owners.
Viewed from an asset perspective, a series arrangement is closely analogous to tracking stock. One state law entity can hold legal title to any number of separate assets, and can issue to different persons interests in separate series representing different assets. This model has long been used by series mutual funds, where it is already enshrined by statute.4 Viewed from a liability perspective, a series arrangement is a simple way to mimic the formation of separate special purpose vehicles to isolate assets of one series from the claims of creditors of another series (or of the series organization itself) for the benefits of different stakeholders. Of course, a series can and usually does have both assets and liabilities, but it is not required to have both.
The proposed regulations essentially provide that each series will be respected as a separate state law entity for purposes of applying the existing entity classification rules. That is, a series will not be treated as part of the series organization simply by reason of the fact that it may be so treated under state law. Once the focus is on the series as opposed to the series organization, the usual rules apply. One must ask whether the series is treated as a separate entity for tax purposes, whether it is an eligible business entity, whether it defaults to a certain classification or has made an election to be classified, etc. Thus, a series that is treated as a separate entity for tax purposes under Regs. §301.7701-1(b) may be classified as a trust, a disregarded entity, a partnership, or a corporation, depending on its activities, how many owners it has, and what elections it has, made (or on how a per se rule applies to it). The identity of a series' owner or owners is determined under existing tax principles.
"Novel" Issues Potentially Implicated by Applying the Proposals to Foreign Series
As a threshold matter, treating each series as separate from the series organization implicates the tax filing and reporting system. It will be the series, and not the series organization, that is eligible to make a check-the-box election for itself, assuming it is an eligible business entity that is not treated as a per se corporation. It will be the series that is required to file any tax returns and complete any required IRS forms such as a Form W-8BEN or W-9. Any other federal election that a taxpayer is capable of making – for example, the §897(i) election – would be made by the series in it own right and would not affect any other series or the series organization. There is nothing about these threshold issues that poses any difficulties as applied to a series created under foreign law.
The issues start to get a little more interesting where the tax rules in question require measurement of ownership. For example, in determining whether U.S.-source interest earned by a foreign person qualifies as portfolio interest, one needs to know whether the foreign person owns 10% or more of the voting stock of a corporate issuer, after applying modified attribution rules. If a foreign series owns less than 10% of the issuer's stock, but another foreign series under the same series organization owns stock of the same issuer sufficient to bring ownership over 10% if the two were aggregated, the question presented is whether the ownership of the two series should be aggregated. In most cases, the answer to this question should be straightforward. If the two series are owned by the same or related parties, application of the attribution rules might vitiate the portfolio interest exemption. But if the owners of the two series are unrelated, there is no reason to aggregate the two. In any case, the question of how to apply attribution rules to a series is a question that arises in the domestic as well as the foreign context, and the answer should, of course, come out to be the same.
Things become still a bit murkier where it is only voting stock that is being counted, which is the case under the portfolio interest 10% shareholder exception as well as under §951(b)'s test for determining who is a U.S. shareholder of a foreign corporation under the subpart F rules. Where voting equity attributable to a series is owned by the same persons who are treated as the owners of a series for tax purposes, there should be no issue or concern. If voting equity is legally held by the series organization itself (where it presumably would be exercised by the board of the series organization) and the series organization actually owns enough equity in the series to be treated as the tax owner thereof, the analysis should be similarly straightforward. The more difficult issue arises where the series organization nominally holds voting equity, but would not be treated as the tax owner of the series. In that event, voting power should be measured based on the substance of the underlying arrangements. As commentators have noted, if the arrangements are such as to give rise to the conclusion that the tax owners of the series exercise de facto control over the series, their interests should be treated as voting stock.5 This is not a particularly difficult rule to work with, and is consistent with current law.
In any case, it is well past time for the IRS to provide guidance as to how to attribute and measure voting power more generally. It has been almost 50 years since subpart F was enacted, demanding as a threshold matter that voting power be measured, and in that time the IRS has never indicated how voting power should be attributed through partnerships and similar entities where voting power and economics can (and usually do) differ. If the extension of these proposed regulations to foreign series is an occasion for the IRS to issue this guidance, then these regulations will have performed an important public service.
If a series organization, rather than a separate series, were treated as a CFC, with the separate series being treated as lower-tier CFCs, application of §951's pro rata rules could skew the economic deal that the parties cut, at least where there are different owners of different series having different assets and income. Fortunately, regulations under §951 provide guidance as to how to apply the pro rata rule to multiple classes of stock.6 However, it is easier simply to posit that each series be treated separately.
Another potentially interesting issue that could arise, at least in theory, is how to treat a foreign series under §892. Suppose that a foreign government created a series organization and a separate foreign series for each of several portfolio investments. Suppose further that one of the series, viewed independently, would be a controlled commercial entity within the meaning of §892(a)(2)(B) but that the other series would not be. If each series is respected as a separate entity, the fact that one series is a controlled commercial entity would not taint the §892 exemption as applied to the other series. However, if each series were treated as a subset of the series organization, the series organization itself would become a controlled commercial entity, with the result that all of the investments of all series would be disqualified from §892 status. Here, treatment of each series as separate is consistent with how the rules of §892 ought to apply.
A similar "tainting" issue arises with respect to effectively-connected income and the §864(b) safe harbors. Again, this issue should not be difficult to deal with in practice. Once one stipulates that each foreign series is a separate entity, the appropriate treatment under these rules follows. There is no reason to suppose that one series should be disqualified from using the safe harbors merely because some other series cannot use them. Nor is there any reason to suppose that the income of one series might be effectively connected with the activities of another. For purposes of applying the complete termination exception to the branch profits tax,7 it should be clear that each series stands on its own as well.
Probably the scariest tax issue associated with foreign series companies is the dreaded PFIC. As a matter of principle, there is absolutely nothing here to be frightened of — if a separate foreign series is a corporation, it is potentially a PFIC, and if it's not a corporation, it's not. What could be simpler?
Unfortunately, and as everyone knows, the PFIC rules are a mess. The first question will be at what level a QEF election can/must be made. Here, the answer seems obvious – the election, like all other elections, should be made at the series level. The second easy question is what assets and income are counted in determining whether a foreign corporate series is a PFIC. The answer is: only its own assets and income, looking down through 25%-controlled subsidiaries if it has any.
PFICs raise a problem identical to that discussed above in connection with CFCs. As commenters have noted,8 the PFIC pro rata rule, contained in §1293(b), is even more difficult, because no regulations have been issued explaining how to apply the rule to different classes of interests. That rule provides that each U.S. shareholder's pro rata share of the PFIC's income items is the amount that would be distributed to such shareholder on a daily basis. In a series fund, the amount that would be distributed is determined based on the rights and entitlements in respect of each separate series, not on the aggregate results of the series organization. Applying the pro rata rule of §1293(b) would thus lead to perverse results if the series organization, rather than each series, were treated as a PFIC — one more argument for extending these proposed regulations to foreign organizations, which §1298(b)(4), among other provisions, gives the IRS clear authority to do.
Whatever issues were troubling the IRS have in any event already arisen, because the proposed regulations would apply to foreign series engaged in the insurance business. This means that PFIC, CFC, and other issues will have to be dealt with anyway. While it is very likely that there are nuances and issues associated with extending the series guidance to foreign entities that I haven't thought of,9 the benefits of certainty in this area are so clear that the IRS should extend the guidance to foreign series.
This commentary also will appear in the November 2010, 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 ¶7110, U.S. International Taxation—General Principles.
1 In Rev. Rul. 2008-8, 2008-5 I.R.B. 340, the IRS analyzed two fact patterns involving insurance issued by one or more cells of a protected cell company. In Notice 2008-19, 2008-5 I.R.B. 366, the IRS requested comments on the treatment of insurance and protected cell companies more generally. In that Notice, the IRS also requested comments on the federal tax treatment of similar segregated arrangements not involving insurance.
9 At a recent ABA conference, an IRS spokesperson suggested that foreign series organizations raise potential issues under the foreign tax credit splitter provisions. If U.S. law treats a series as a separate person with its own income, but foreign law treats the series organization as the technical taxpayer, any foreign tax on the series' income could end up in the wrong place. But this problem seems no different than the well-known Guardian Industries problem already being addressed under the splitter rules, and in any event seems capable of being used affirmatively by taxpayers only where there is common ownership of all series, a case that is easily addressed.
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