Many taxpayers already know about the “check the box” (CTB) election that permits one to choose the US taxable form of a legal entity as either a corporation, a flow-through “partnership” or a “disregarded entity.” This election is typically made within 75 days of the formation of a legal entity, although a “late election” is frequently granted. Except for so-called “per se” legal forms that always must be taxed as a corporation, there is a wide variety of (usually) limited liability vehicles, including LLP’s and LLC’s and their equivalents under foreign law, for which the CTB election can be made. Having the discretion to choose the taxable form of a legal entity can make a real difference in international tax planning. Here are two examples for your consideration.
In our first example, a US Subchapter S corporation (USS), owned by a few US citizens, owns 100% of a foreign company (CE) in Country E. Although CE previously operated an active business, all of its assets have been sold and it currently holds liquid funds and investments in shares and bonds. Country E doesn’t impose a “normal” corporate income tax. Instead, only when assets are distributed to a shareholder are the profits taxed to the corporation. (This is not a withholding tax, but a corporate income tax triggered by the distribution of assets.) But because the owners of USS, as US citizens, can only obtain foreign tax credits for direct foreign taxes and not for “deemed paid” foreign taxes, a distribution by CE of its assets to USS would trigger a non-creditable Country E corporate tax and result in double taxation to the USS shareholders – once at the level of CE, and again in the hands of the USS shareholders.
The remedy in the above case is to adopt a plan of liquidation of CE under the laws of Country E, and to file a CTB election on CE to convert it into a “disregarded entity” of USS, for US tax purposes. Now the actual liquidating distribution of the assets of CE under the plan of liquidation is mirrored by a deemed distribution of the CE assets in the deemed liquidation of CE by virtue of the CTB election. Accordingly the tax imposed on CE by Country E on the distribution of CE’s assets to USS now becomes a direct tax on the income recognized by the US shareholders in the deemed liquidation, and therefore a creditable tax against their US tax liability on that liquidating distribution. In this way, double taxation has been avoided and the shareholders of USS are able to “bring home the bacon” with only one level of tax.
In our second example, a US Subchapter S corporation (USS,) owned by two US citizens, owns a Hong Kong corporate subsidiary, which in turn owns a Chinese corporate subsidiary. Both foreign companies are involved in managing independent contract manufacturers who produce goods for sale by USS. Through employees based in China, the Chinese subsidiary carries on management and oversight functions with the Chinese contract manufacturers, sources the raw materials and performs other acts that contribute substantially to the manufacture of the goods. Under US tax law, because the Hong Kong company purchases the goods from unrelated manufacturers outside Hong Kong and sells them to its shareholder, USS, the income from those sales is taxable currently in the hands of the owners of USS under a US tax anti-deferral provision known as “Subpart F” income – even if the income never actually leaves Hong Kong. This results in double taxation to the owners of USS, because foreign tax credits with respect to Subpart F income in the hands of individual taxpayers are not effective in avoiding double taxation.
A complex set of rules governing the use of contract manufacturing arrangements would provide an exception from Subpart F income, to the extent that the Hong Kong company is considered the manufacturer of the goods for US tax purposes. These require that the Hong Kong company make a “substantial contribution” to the Chinese manufacturing process, based on seven criteria provided in tax regulations. Moreover, this substantial contribution must be made by employees of the Hong Kong company. However, the employees in question are in China and work for the Chinese subsidiary.
The remedy in this case is to file a CTB election with respect to the Chinese subsidiary of the Hong Kong company. As a wholly-owned subsidiary, the “checked” Chinese company now becomes a “disregarded entity” of its Hong Kong parent – effectively, a Chinese “branch” of the Hong Kong parent – for US tax purposes. (The CTB election has no effect under Hong Kong or Chinese law.) As a result, the employees of the Chinese subsidiary are now considered employees of the Hong Kong parent – again, for US tax purposes only – and the important value-adding activities taking place in China through those employees are attributed to the Hong Kong parent. That company now satisfies the contract manufacturing rules and Subpart F doesn’t apply.
These are only two of the myriad ways in which the CTB election can be used in international tax planning. If you have questions regarding the taxation of your international operations, please contact the author at firstname.lastname@example.org.
FGMK is a Chicago-based assurance, tax and advisory firm. For more than 40 years, FGMK has recommended strategies that give our clients a competitive edge. As a leader among the top Regional Accounting firms in the Midwest, FGMK is ranked one of the 10 largest accounting firms in Chicago by Crain’s Chicago Business and is amongst the 100 largest accounting firms nationally. Our clients include privately held businesses, global public companies, private equity firms and entrepreneurs. Our value proposition is to offer clients a hands-on operating model, with our most senior professionals actively involved in client service delivery.
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