Check-the-Box: Not Always the Right Answer for Certain Foreign Corporations

Taxpayers and tax advisers have found the “check the box” rules to provide excellent opportunities for tax planning and tax compliance simplification. Specifically, Sec. 7701 and Regs. Sec. 301.7701-3 allow individual and corporate owners of corporations meeting limited liability requirements to elect whether to treat the entity as:

1. A taxable corporation;

2. An entity disregarded from its owner; or

3. A partnership, if there is more than one shareholder.

The check-the-box election gives U.S. shareholders of foreign entities flexibility and certainty. The certainty comes from electing how the entity will be treated for U.S. tax purposes. Flexibility is afforded to shareholders by allowing them to construct an organization that meets the business’s tax and economic needs.

Entity Classification—Use

The check-the-box election has been particularly useful to U.S. flow-through entities that have foreign operations. The owners of flowthrough entities (S corporations and partnerships) cannot claim the deemed paid (indirect) tax credit provided by Sec. 902. That is, the taxes paid by the foreign subsidiary are not available for credit to the owners of a flowthrough entity, creating double taxation. However, when an election is made to treat the foreign subsidiary as a disregarded entity, all of the income and deductions (including foreign taxes) are treated as earned directly by the flowthrough entity. As a result, the foreign taxes are considered direct taxes and are available for credit to the owners.

The flowthrough election has been a boon to tax planning and has become one of the most commonly used techniques by advisers. However, an often overlooked potential drawback to the election is the loss of the ability to defer income. Multinational companies with a variety of enterprises throughout the world often benefit from being able to align repatriation of income to maximize the use of tax credits and other tax attributes. In a flowthrough environment, other planning steps must be undertaken to meet the organization’s needs.

It is incumbent on tax advisers to examine all the facts and circumstances to ensure that taxpayers’ needs are being met. In some situations, taxpayers and their advisers are not in a position to plan for the difficulties of flow-through income from all sources. Rather, advisers must seek all available opportunities before recommending a check-the-box election.

An assessment of how the election will affect the taxpayer’s business, needs and desires must always be a consideration. As discussed, lack of integration with the use of tax attributes created by foreign entities may eliminate the double tax edge gained by the flowthrough election.

When analyzing the effect of a potential check-the-box election, the overall tax rate on the foreign income is critical. For instance, if income in a particular jurisdiction is taxed at zero or some other low rate, retention of the deferral opportunity by not making the election would be compelling, because the overall effective tax rate may be unaffected or only marginally affected.

Further, in a multiple-entity setting in which entities are at various stages of development, the strategy of retaining deferral at a holding-company level while making the election at the operating-company level may create a mix of tax attributes (i.e., income, losses, and untaxed and taxed items) that could be beneficial to worldwide tax planning.

Qualified Dividend Income

Another area of consideration is the effect of the Jobs and Growth Tax Relief Reconciliation Act of 2003 reduction of the tax rate on qualified dividends to 15% for individuals. For certain taxpayers the rate may be lower. Dividends received from foreign corporations qualify for the reduced rate if:

1. The foreign corporation is incorporated in a U.S. possession;

2. The foreign corporation is eligible for the benefits of an income tax treaty with the U.S., which includes an information exchange program that the IRS determines as satisfactory; or

3. The stock with respect to which the dividend is paid is taxable on an established U.S. securities market.

Note: in Notice 2003-69, the IRS identified approximately 50 treaties that satisfy the information exchange requirements.

The reduced rate on dividends is currently scheduled to expire after Dec. 31, 2008.

Qualified Dividends and Entity Planning

Qualified dividends can be beneficial.

Example: U.S. taxpayer, T, made an investment in foreign country, X, which has a qualifying treaty with the U.S. X administers its tax at 10% and does not impose a withholding on dividend distributions. T earns $1 million; thus, the applicable foreign tax will be $100,000. A check-the-box election was not made, and, barring intervention by one of the Code’s anti-abuse sections, the income will not be taxed in the U.S. until repatriation.

Income repatriated prior to the expiration of the preferential dividend rate will create U.S. Federal income tax to the shareholders at 15%. The blended rate of tax (Federal and foreign) will be 23.5% (the rate is the result of an after-tax foreign distribution of $900,000 taxed at 15% added to the original tax of $100,000 on the initial earnings). The taxpayer gains the time value of money and is able to hold its worldwide tax rate to 10%, less than if it had checked the box.

Pitfalls

Taxpayers and their advisers must be fully aware of the requirements necessary to receive preferential dividend treatment. Aside from the treaty requirement, deemed income from the anti-abuse sections of subpart F do not qualify for the preferential rate. Further, dividends from passive foreign investment companies do not qualify. Certain other limits also apply that preclude qualification for the preferential rate.

Conclusion

While the entity-classification election rules provide taxpayers with good planning opportunities, consideration should be given to situations in which treating an entity as disregarded may not be in the taxpayer’s favor.

From Robert Patelski, CPA, MST, Schaumburg, IL