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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
Reg. §301.7701-2(b)(6) of the entity classification regulations (the "Regulation") is a perfect example of a regulation drafted by a person who gave little or no thought to what he/she was trying to accomplish, or what the collateral effects of the Regulation might be. It says nothing, and everything. It exists, apparently without purpose.
The Regulation provides in full as follows: "For federal tax purposes, the term corporation means—A business entity wholly owned by a State or any political subdivision thereof, or a business entity wholly owned by a foreign government or any other entity described in §1.892-2T."
The term "wholly owned" is entirely ambiguous. To begin with, what does "owned" mean? Does it refer to economic ownership or to the entire bundle of rights we normally think of as "ownership"? Next, what does "wholly" mean? Does it incorporate notions of indirect and constructive ownership? If these questions sound petty, consider the following examples.
Example One. Suppose that foreign government FG has an interest in a commercial law partnership (which could be a domestic or foreign business entity) entitling it to 100% of the profits up to a threshold after which partner B is entitled to a carried interest of 20%. Partner B has no capital invested in the partnership. Is the partnership wholly owned by FG? If so, it will be classified under the Regulation as a corporation, which might come as a surprise to most folks, given that the general entity classification rules would clearly respect its classification as a partnership, or at least a disregarded entity.
Example Two. Suppose that FG forms a 100% directly owned business entity (Sub) in a different foreign country, such that Sub would not qualify as a foreign government within the meaning of Reg. §1.892-2T. (It does not qualify because to be a controlled entity and thus a type of foreign government described in the regulations, it must be formed in the same foreign country as FG is formed in.) It appears that the Regulation would treat Sub as a corporation even though, under the general entity classification rules, it might elect to be treated as a disregarded entity. Next suppose that Sub creates a wholly owned, second-tier, foreign business entity X that is an eligible entity because it is not listed on the per se list in Reg. §301.7701-2(b)(8). Here, X is not directly owned by a foreign government. Can Sub treat X as a disregarded entity, or is X treated as "wholly owned," albeit indirectly, by FG such that it must be classified as a corporation? And if the latter, why? What is the purpose of this per se rule?
In a June 2008 report, the Tax Section of the New York State Bar Association surveyed the history of the Regulation.2 The Regulation originally covered only state and local governments. The reason for the Regulation in that context was that, under §115, state and local governments are able to earn income from commercial activities that is exempt from federal tax, so long as they earn it directly. Their exemption is far more limited where they own a separately-incorporated subsidiary. The Regulation was thus intended to prevent them from using a disregarded entity in lieu of a separately-incorporated subsidiary.
The Regulation was amended in 2002 to extend to foreign governments. Ostensibly, the reason was that the IRS had the same concern as noted above for state and local governments. However, as the NYSBA report pointed out, there is no parallel concern. Unlike state and local governments, foreign governments do not enjoy a tax exemption for any income from commercial activities. Thus, as applied to foreign governments, the Regulation serves no purpose.
Despite first appearances, there is a lot at stake here. Example One is a fairly common trap for the unwary, and it's a very bad trap to be caught in. Many private equity firms will use one or more parallel funds organized as Delaware partnerships to tailor their operating provisions to different classes of investors, including foreign governments described in §892. The general partner/sponsor of the main fund will typically take a carried interest in the parallel fund, but in most cases would not contribute capital to the parallel fund, because its capital is all invested in the main fund. If, as luck might have it, there is only one foreign government investor in the parallel fund, under the Regulation the parallel fund will be classified as a Delaware corporation unless the general partner's carried interest is deemed sufficient to make the parallel fund less than "wholly owned" by the foreign government partner. The consequences of being treated as a Delaware corporation would be disastrous, because all of the fund's worldwide income would be taxable in the United States. This result is especially perverse if the fund invests solely or primarily outside of the United States. And note that even if the parties form the parallel fund as a foreign partnership, default to corporate status would mean that it is not a foreign government described in §892 unless it was formed in the same country as the foreign government is formed in.
To avoid this risk, the foreign government investor will usually insist that the general partner invest more than nominal capital in the parallel fund, thereby ensuring that the general partner will be treated as a partner such that the fund will not be "wholly owned" by the foreign government. What constitutes a meaningful enough amount of capital is unclear. Given the stakes, most investors will insist on sufficient capital being invested by the general partner to satisfy pre-check-the-box Rev. Proc. 89-12, 1989-1 C.B. 798. It will be recalled that that revenue procedure set out minimum capital amounts that a general partner needed to have at risk before being respected as a general partner, giving the partnership "unlimited liability" under the old Kintner regulations. Under the general rule of the revenue procedure, the interests of all the general partners, taken together, in each material item of partnership income, gain, loss, deduction, or credit had to equal at least 1% at all times during the existence of the partnership, with only limited exceptions as to timing. If that test was not met, the general partner had to demonstrate that its interest was nevertheless material, and under that test a profits interest could be shown to be material under certain conditions. Nevertheless, if certainty was needed, the materiality test would not be relied upon.
Under a special rule for large partnerships, the 1% requirement was lowered to at least 1% divided by the ratio of total partnership contributions to $50 million. In no event could the general partners' aggregate interest at any time in any material item be less than 0.2%. This 0.2% capital requirement has become, for lack of any clearer rule, the standard used to avoid the "wholly owned" trap.
This issue has been around a long time. But the proximate cause of this short commentary was, of all things, the recently issued proposed regulations under §707(a)(2).3 Normally an international tax person would pay only passing attention to regulations that ostensibly were issued to warn private equity sponsors that their fee waiver techniques might be challenged. Interesting, but what has this got to do with me?
The §707(a)(2) regulations are commendable in that they do not focus myopically on the fee waiver issue. Instead, they take many steps back and revisit everything we know about disguised payments for services, and whether a person receives such payments as a distributive share of partnership income, in his capacity as a partner within the meaning of §707(c), or as an independent service provider under §707(a). The Preamble reads like a law review article.
The Preamble makes clear the intention to apply the proposed rules for all purposes of the Code. Thus:
These proposed regulations apply to a service provider who purports to be a partner even if applying the regulations causes the service provider to be treated as a person who is not a partner… . Further, the proposed regulations may apply even if their application results in a determination that no partnership exists.
If the §707(a) regulations are finalized in their present form, it seems likely that more commercial law partnerships will be disregarded or at least that the general partner will be treated as not a partner. In that event, the Regulation will apply to treat these entities as corporations. Here we have another case of the unintended consequences of the Regulation.
Example Two is part of a larger problem. The IRS's current position under §892 is that a foreign government that is separately incorporated will be treated as a "controlled entity" and as a "controlled commercial entity" disqualified under §892 if it is a U.S. real property holding corporation (the "USRPHC rule").4 What this means in practice is that no foreign government can form a special purpose corporation to hold title to U.S. real property without foregoing the benefits of §892. Since the principal benefit of §892 for foreign governments is the ability to sell stock of a noncontrolled USRPHC without tax,5 the foreign government is forced to hold U.S. real property directly together with sufficient other qualifying assets -- often interests in foreign real property -- such that it avoids being treated as a USRPHC. It is unable to place separate properties in separate limited liability entities, thereby exposing its properties to the liabilities associated with other properties.
In normal real estate portfolios, owners make use of single-member limited liability companies that are disregarded for U.S. income tax purposes to "silo" one property from another. A foreign government is unable to do this with respect to U.S. real property, because the Regulation will deem the limited liability company to be a corporation and the USRPHC rule will deem that corporation to be a controlled commercial entity. The Regulation thus prevents a foreign government from dealing with the USRPHC rule in a normal, commercial manner. This is a case of one purposeless rule (the Regulation) being combined with a second purposeless rule (the USRPHC rule) to produce a preposterous result.
This commentary also will appear in the September 2015 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Streng, 700 T.M., Choice of Entity, Caballero, Feese, and Plowgian, 912 T.M., U.S. Taxation of Foreign Investment in U.S. Real Estate, Nikravesh, Maloney, and Dick, 913 T.M., U.S. Income Taxation of Foreign Governments, International Organizations, Central Banks, and Their Employees, and in Tax Practice Series, see ¶7120, Foreign Persons – Gross Basis Taxation, ¶7140, Foreign Persons — FIRPTA.
Copyright©2015 by The Bureau of National Affairs, Inc.
With apologies to Milan Kundera, The Unbearable Lightness of Being (2005).
2 "Report on the Tax Exemption for Foreign Sovereigns Under Section 892 of the Internal Revenue Code," Report #1157, at pp. 31-33 (June 2008).
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