Treasury and Internal Revenue Service Issue Regulations That Treat A Defective Entity Owned By a Foreign Person As a Domestic Corporation For Certain Tax Compliance Purposes

By: Jerald David August

On December 12, 2016, the Service (and Treasury) issued Final Regulations in T.D. 9796 on the treatment of certain domestic entities that are disregarded from their owners as corporations for purposes of Section 6038A.

Background to Section 6038A

Section 6038A and section 6038C set forth reporting, record-keeping and enforcement rules for related party transactions involving foreign-owned domestic corporations and for all items affecting tax liabilities of foreign corporations engaged in business in the United States [1]. Section 6038A was enacted in 1982 and was intended by Congress to create greater transparency on related party transactions between a U.S. parent corporation and its foreign affiliates as well as foreign controlled U.S. entities, which latter set of transactions was imposed for foreign corporations (“reporting corporations) engaged in a trade or business within the United States in accordance with Section 6038C [2]. Section 6038C was enacted in 1990 [3]

Issuance of Proposed Regulations In May, 2016.: Application to Disregarded Entities

Treas. Regs. §§301.7701 – Treas. Reg. §301.7701-3 (the check-the-box regulations) allows a business entity having 2 or more members to be classified for U.S. income tax purposes either as a corporation or a partnership and a business entity having a single owner as either a corporation or an entity that is disregarded as separate from its owner, i.e., a disregarded or “defective” entity [4]. Certain domestic business entities such as limited liability limited partnership or limited liability companies are, by application of a default rule, treated as partnerships or as disregarded entities if they only have one owner but are eligible to elect (Form 8832) to be treated as corporations for U.S. income tax purposes. Generally a domestic partnership or corporation is required to file a tax (or informational) return and obtain an EIN. In contrast, however, a disregarded or “defective” entity is not subject to a separate income or informational return requirement. Instead, the reporting is made by the individual owner. For a disregarded entity that is formed in the U.S. and  wholly owned by a foreign corporation, foreign partnership, or nonresident alien individual, generally no U.S. income or information return must be filed if neither the disregarded entity nor its owner received any U.S. source income or was engaged in a U.S. trade or business during the tax year. Moreover, if a disregarded entity only receives certain types of U.S. source income, such as portfolio interest or U.S. source income that is fully withheld upon at source, its owner may not have a U.S. return filing requirement.

Section 6038A imposes reporting, compliance and recordkeeping requirements (together with certain procedural compliance requirements) on domestic corporations that are at least 25% foreign-owned. They are required to file an annual return on Form 5472 (Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business) with respect to each related party with which the reporting corporation has had any reportable transactions. Treas. Reg. § 1.6038A-2. These corporations must keep the permanent books of account or records as required by section 6001 that are sufficient to establish the accuracy of the federal income tax return of the corporation, including information, documents, or records to the extent they may be relevant to determine the correct U.S. tax treatment of transactions with related parties. Treas. Reg. § 1.6038A-3.

Regulations Project On Single Member Domestic Defective Entities Having Foreign Owner

Last Spring, the Treasury and the IRS issued proposed regulations (REG-127199-15; 81 FR 28784) under sections 6038A and 7701. The proposed regulations under Prop. Reg. §301.7701-2(c), treat a domestic disregarded entity wholly owned by a foreign person as a domestic corporation separate from its owner for the limited purposes of the reporting, record maintenance and associated compliance requirements that apply to 25%  foreign-owned domestic corporations under section 6038A.

The proposed regulations were to be effective for taxable years of the entities described in §301.7701- 2(c)(2)(vi) ending on or after the date that is 12 months after the date of publication of the Treasury decision adopting the proposed rules as final regulations in the Federal Register. The government at that time asked for comments on the proposed rulemaking specifically requested comments on possible alternative methods for reporting a domestic disregarded entity's transactions in cases in which the foreign owner of the domestic disregarded entity already has an obligation to report the income resulting from those transactions-for example, transactions resulting in income effectively connected with the conduct of a U.S. trade or business. Ironically, no comments were received and no public hearing was requested or held.

The final regulations were issued on December 12, 2016. For purposes of section 6038A, the final regulations, consistent with the proposed regulations, require that a domestic disregarded entity wholly owned by a foreign person, e.g., reverse hybrid entity, be treated as a “domestic corporation” separate from its owner, but only for the reporting, record maintenance and other associated compliance requirements. As domestic corporations for purposes of section 6038A, they are required to file IRS Form 5472 for reportable transactions between the entity and its foreign owner or other foreign related parties. There business and tax records required to be maintained to corroborate the accuracy of the information and correct U.S. tax treatment of such transactions. By virtue of the entity’s filing obligation, it is required to obtain an EIN (per Form SS-4) that includes responsible party information. In addition to reporting all transactions with foreign related parties, the final regulations set forth an additional reportable category of any transaction described under Treas. Reg. §1.482-1(i)(7), i.e., 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.

As per the proposed regulation, Treas. Reg. §1.6038A-1(h) sets forth exceptions to the record maintenance requirements for small corporation, i.e., corporations having less than $10M in U.S. gross receipts per year and for de minimus transactions, i.e., any tax year in which the aggregate value of gross payments that the reporting corporation makes to and receives from foreign related parties with respect to related party transactions isn't more than $5 million and is less than 10% of its U.S. gross income). Special overlap rules are addressed concerning CFC and foreign sales corporations.

The proposed regulations had an effective date on or after 12 months after the date the regulations were published in final form. See Prop. Reg. §1.6038A-1(n). The final regulations provide the new rules apply to tax years of entities beginning on or after January 1, 2017 and ending on or after December 31, 2017. Treas. Reg. §1.6038A-1(n).

[1] See Form 5472 (§6038A). Pridjian, “Using a Shotgun When a Pistol Would Do—An Examination of the Information Reporting and Recordkeeping Requirements for Foreign-Owned Corporations (Section 6038a Regulations),” 11 Va. Tax Rev. 427 (1991); Warden, “New Information Requirements for Foreign-Owned Corporations,” 46 Tax Notes 953 (Feb. 19, 1990).

[2] Staff of Joint Comm. on Tax'n, 97th Cong., 2d Sess., General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982 at 250 (Comm. Print 1982).

[3] P.L. 101-508, §11315(a).

[4] Special rules apply to foreign corporations, including “per se” foreign corporations.

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