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This page contains a single entry by lsaret published on March 2, 2009 1:08 AM.

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Proposed Conduit Financing Regulations Treat Disregarded Entities as Regarded Entities

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By Jeffrey "Jeff" Rubinger

On December 22, 2008, the IRS issued proposed regulations (the Proposed Regulations) (REG-113462-08) under Regulation Section 1.881-3 that "clarify" that the term "person" includes an entity that is disregarded as an entity separate from its single owner (i.e., a disregarded entity) under the "check-the-box" regulations.1  As a result, under the Proposed Regulations, any transaction that the disregarded entity enters into will be taken into account for purposes of determining whether a conduit financing arrangement exists.2

This is not the first time the IRS has attempted to treat transactions entered into with disregarded entities as having significance for U.S. federal income tax purposes. For example, in July 1999 the IRS issued proposed regulations under Section 1.954-9 that treated certain "hybrid branch" payments as giving rise to subpart F income, despite the fact that if the hybrid branch were characterized as a disregarded entity for U.S. federal income tax purposes, no subpart F income would arise.3  Similarly, in December 1999 the IRS issued proposed "extraordinary transaction" regulations under Section 301.7701-3, in which a foreign disregarded entity would be treated as an association taxable as a corporation if a 10 percent or greater interest in such entity were disposed of either one day before or within 12 months after the effective date of such entity's conversion from an association taxable as a corporation into a disregarded entity under the check-the-box regulations.4  Notably, neither of these regulations was ever finalized.5

Despite the fact that the Preamble indicates that the Proposed Regulations merely "clarify" that a disregarded entity is treated as a person for purposes of determining whether a conduit financing regulations exists, the Proposed Regulations will be effective only for payments made on or after the date the regulations are issued in final form.6

Taxation of Foreign Persons and Availability of Treaty Benefits

Foreign persons are subject to U.S. federal income taxation on a limited basis. Unlike U.S. persons who are subject to U.S. federal income tax on their worldwide income, foreign persons generally are subject to U.S. taxation on two categories of income: (i) certain passive types of U.S. source income (e.g., interest, dividends, rents, annuities and other types of "fixed or determinable annual or periodical income," collectively known as FDAP);7 and (ii) income that is effectively connected to a U.S. trade or business (ECI).8  FDAP income is subject to a 30 percent withholding tax that is imposed on a foreign person's gross income (subject to reduction or elimination by an applicable income tax treaty) and ECI is subject to tax on a net basis at the graduated tax rates generally applicable to U.S. persons.

For a non-U.S. taxpayer to be eligible for reduced withholding tax rates on U.S.-source FDAP income under a U.S. income tax treaty, the taxpayer must be considered a resident of the particular treaty jurisdiction and must satisfy any limitation on benefits (LOB) provision in the treaty. Under most U.S. income tax treaties, a foreign person will be considered a resident for treaty purposes if such person is "liable to tax therein by reason of its domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature."9

Similarly, under most "modern" income tax treaties, a corporate resident of a treaty country can satisfy the LOB provision if: (i) on at least half the days of the taxable year, at least 50 percent of each class of shares in the corporation is owned, directly or indirectly, by residents of the jurisdiction where the corporation is formed (the "ownership test"),10 and (ii) not more than 50 percent of the gross income of the foreign corporation is paid or accrued, in the form of deductible payments, to persons who are residents of the United States or residents of the jurisdiction where the corporation is formed (the "base erosion" test).11

Pre-Section 7701(l) Guidance

Prior to the enactment of Section 7701(l), the IRS typically would challenge a back-to-back loan or license arrangement under Aiken Industries, 56 T.C. 925 (1971) or Rev. Rul. 80-362, 1980-2 C.B. 208, respectively. In Aiken, the IRS successfully argued that interest payments made by a U.S. corporation to a Honduran corporation (which collected the interest on behalf of a Bahamian corporation) were not exempt from U.S. withholding tax under the U.S.-Honduras income tax treaty then in effect. The Tax Court agreed with the IRS and reasoned that the Honduran corporation, while a valid resident under the U.S.-Honduras treaty, had no "dominion and control" over the funds and was a mere collection agent or "conduit for the passage of interest payments" from the U.S. entity to the Bahamian entity.12

In Rev. Rul. 80-362, a resident of a non-treaty jurisdiction licensed a patent to a Dutch corporation, which in turn sublicensed the patent to a U.S. corporation for use in the United States. The royalties paid from the United States to the Netherlands were exempt from withholding tax under the Netherlands-U.S. income tax treaty. The IRS ruled, however, that the royalties paid from the Netherlands to the non-treaty jurisdiction were U.S.-source royalties under Section 861(a)(4) because they were paid in consideration for the privilege of using a patent in the United States. Therefore, those royalties were subject to a 30 percent withholding tax in the United States.13

Section 7701(l) and Regulation Section 1.881-3

In 1993, Congress enacted Section 7701(l), authorizing the Treasury to prescribe regulations recharacterizing any multiple-party financing transaction as a transaction directly among any two or more of such parties where it is determined that such recharacterization is appropriate to prevent the avoidance of any tax imposed by the Code. In 1995, the IRS issued regulations under Regulation Section 1.881-3 relating to conduit financing arrangements pursuant to the authority granted by Section 7701(l).

In general, Regulation Section 1.881-3 allows the IRS to disregard the participation of one or more intermediate entities in a financing arrangement where such entities are acting as conduit entities, and to recharacterize the financing arrangement as a transaction directly between the remaining parties to the financing arrangement for purposes of imposing tax under Sections 871, 881, 1441 and 1442.14 For this purpose, a financing arrangement is defined as a series of financing transactions by which one person (the financing entity) advances money or other property, or grants rights to use property, and another person (the financed entity) receives money or other property, or rights to use property, if the advance and receipt are effected through one or more other persons (intermediate entities).15 Except in certain cases dealing with related parties, the regulations apply only if financing transactions link the financing entity, each of the intermediate entities, and the financed entity.16

A "financing transaction" means (i) debt; (ii) any lease or license; or (iii) any other transaction (including an interest in a trust described in Sections 671 through 679) pursuant to which a person makes an advance of money or other property or grants rights to use property to a transferee who is obligated to repay or return a substantial portion of the money or other property advanced, or the equivalent in value.17

Notably, stock in a corporation (or a similar interest in a partnership or trust) will constitute a financing transaction only if one of the following conditions is satisfied:

    (i) The issuer is required to redeem the stock or similar interest at a specified time or the holder has the right to require the issuer to redeem the stock or similar interest or to make any other payment with respect to the stock or similar interest;

    (ii) The issuer has the right to redeem the stock or similar interest, but only if, based on all of the facts and circumstances as of the issue date, redemption pursuant to that right is more likely than not to occur; or

    (iii) The owner of the stock or similar interest has the right to require a person related to the issuer (or any other person who is acting pursuant to a plan or arrangement with the issuer) to acquire the stock or similar interest or make a payment with respect to the stock or similar interest.18
If the IRS determines that the participation of a conduit entity in a financing arrangement should be disregarded, the financing arrangement is recharacterized as a transaction directly between the remaining parties to the financing arrangement (in most cases, the financed entity and the financing entity) for purposes of Section 881.19 Where the participation of a conduit entity in a conduit financing arrangement is disregarded, it is disregarded for all purposes of Section 881, including for purposes of applying any relevant income tax treaties.20  Accordingly, the conduit entity may not claim the benefits of a tax treaty between its country of residence and the United States to reduce the amount of tax due under Section 881 with respect to payments made pursuant to the conduit financing arrangement.21  The financing entity may, however, claim the benefits of any income tax treaty under which it is entitled to benefits in order to reduce the rate of tax on payments made pursuant to the conduit financing arrangement that are recharacterized under the regulations.22

For this purpose, an intermediate entity will be acting as a conduit entity with respect to a financing arrangement if (i) the participation of the intermediate entity (or entities) in the financing arrangement reduces the tax imposed by Section 881; or (ii) the participation of the intermediate entity in the financing arrangement is pursuant to a tax avoidance plan, and either the intermediate entity is related to the financing entity or the financed entity, or the intermediate entity would not have participated in the financing arrangement on substantially the same terms but for the fact that the financing entity engaged in the financing transaction with the intermediate entity.23

One of the principal purposes of a tax avoidance plan is the avoidance of tax imposed by Section 881.24 The regulations identify several factors that the IRS will look at in determining whether the participation of an intermediate entity in a financing arrangement has as one of its principal purposes the avoidance of tax imposed by Section 881. Among the factors listed are: (i) whether the participation of the intermediate entity in the financing arrangement significantly reduces the tax that would otherwise be imposed under Section 881; (ii) whether the intermediate entity had the ability to make the advance without the advance of money to it by the financing entity; (iii) the time period between the financing transactions; and (iv) whether the financing transaction occurs in the ordinary course of business.25

Significantly, the regulations contain a rebuttable presumption that the participation of an intermediate entity (or entities) in a financing arrangement will not be treated as a tax avoidance plan if the intermediate entity is related to either or both the financing entity or the financed entity and the intermediate entity performs significant financing activities with respect to the financing transactions forming part of the financing arrangement to which it is a party.26

For purposes of this provision, an intermediate entity is considered to perform significant financing activities with respect to leases or licenses if rents or royalties earned with respect to such leases or licenses are derived in the active conduct of a trade or business within the meaning of Section 954(c)(2)(A), to be applied by substituting the term "intermediate" entity for the term "controlled foreign corporation" (as defined under Section 957(a)).27

Furthermore, an intermediate entity is considered to perform significant financing activities with respect to financing transactions only if officers and employees of the intermediate entity participate actively and materially in arranging the intermediate entity's participation in such financing transactions and perform the business activity and risk management activities with respect to such financing transactions, and the participation of the intermediate entity in the financing transactions produces (or reasonably can be expected to produce) efficiency savings by reducing transaction costs and overhead and other fixed costs.28

Check-the-Box Regulations

Prior to the issuance of the check-the-box rules, an unincorporated association was treated for federal tax purposes as either a corporation or a partnership, depending on whether the entity possessed certain corporate characteristics (i.e., free transferability of interests, centralization of management, continuity of life, and limited liability). If the association had at least three of these characteristics, it was treated as a corporation for federal tax purposes. If it had fewer than three of these corporate characteristics, however, the association generally was classified as a partnership for federal tax purposes.

The check-the-box regulations, which apply for all federal tax purposes, simplified matters greatly. Unless the taxpayer elects otherwise on Form 8832, a domestic eligible entity will be treated as (i) a partnership if it has two or more members, or (ii) disregarded as an entity separate from its owner if it has a single owner.29  Similarly, for a foreign eligible entity, unless the taxpayer elects otherwise, such an entity will be treated as (i) a partnership, if it has two or more members and at least one member does not have limited liability, (ii) an association, if all members have limited liability, or (iii) disregarded as an entity separate from its owner if it has a single owner that does not have limited liability.30  If an entity is disregarded for U.S. federal income tax purposes, its activities are "treated in the same manner as a sole proprietorship, branch, or division of the owner."31

Proposed Conduit Financing Regulations

As noted above, the Proposed Regulations contain a new provision that indicates that "the term person includes a business entity that is disregarded as an entity separate from its single member owner under sections 301.7701-1 through 301-7701-3."32 As a result, any transaction that the disregarded entity enters into will be taken into account for purposes of determining whether a conduit financing arrangement exists.  The sole example contained in the Proposed Regulations involves, in effect, a back-to-back loan arrangement. FP, a foreign corporation organized in a jurisdiction that does not have an income tax treaty with the United States (e.g., the Cayman Islands), lends $1 million to DS, a corporation organized in the United States, in exchange for a note issued by DS. A year after making the original loan, FP assigns the DS note to FS, a wholly-owned foreign subsidiary of FP organized in a jurisdiction that has an income tax treaty with the United States (e.g., the Netherlands) in exchange for a note issued by FS. The DS-FS income tax treaty eliminates withholding tax on dividends, interest and royalties. FS is a disregarded entity under the check-the-box regulations. (See Diagram 1.) After receiving notice of the assignment, DS remits payments due under its note to FS. According to the example, because the term "person" includes a disregarded entity under the Proposed Regulations, FS is treated as a person and therefore may itself be an intermediate entity that is linked by financing transactions to other persons in a financing arrangement. The DS note held by FS and the FS note held by FP are financing transactions, and together constitute a financing arrangement. Therefore, under the example, the interest paid from DS to FS would not be eligible for the reduced withholding tax rates under the DS-FS income tax treaty, but rather would be subject to a 30 percent U.S. withholding tax.33

Arguably, without the Proposed Regulations, this transaction would not appear to be subject to the conduit financing regulations: the existence of FS would be ignored for U.S. federal income tax purposes under the check-the-box regulations, and therefore FS would not be considered an intermediate or conduit entity. This argument would seemingly be strengthened by recently issued proposed regulations under Section 901, as well as current regulations under 1441, which specifically do not treat a disregarded entity under the check-the-box regulations as a person.34 As a result, the interest paid from DS to FS arguably would be eligible for treaty benefits under the DS-FS income tax treaty, despite FS being characterized   as a disregarded entity for U.S. federal income tax purposes, because the interest payment would be "derived" by a resident of a treaty jurisdiction.35

Although the only example in the Proposed Regulations deals with a situation where the "conduit" or "intermediate" entity is a disregarded entity organized in a treaty jurisdiction, the broad scope of the Proposed Regulations, including the statement in the Preamble that "any transaction that the disregarded entity enters into will be taken into account for purposes of determining whether a conduit financing arrangement exists," indicates that the Proposed Regulations would also apply in the reverse situation. For example, assume in the facts described above that FP is organized in a treaty jurisdiction (e.g., the Netherlands) and FS is organized in a non-treaty jurisdiction (e.g., the Cayman Islands). Also assume that FS is a disregarded entity under the check-the-box regulations. (See diagram 2.) If FS advances money to FP, which in turn advances money to DS, the Proposed Regulations would treat FS as a person and would therefore characterize the back-to-back loan arrangement as a conduit financing arrangement. Accordingly, under the Proposed Regulations, the arrangement would be recharacterized as a transaction directly between DS and FS. Because no income tax treaty exists between DS and FS in this situation, the interest paid from DS would be subject to a 30 percent U.S. withholding tax.36

A similar analysis would appear to apply with a disregarded U.S. LLC that is part of a conduit financing arrangement under the Proposed Regulations. For example, assume that a Norwegian company wholly owns a U.S. LLC that defaults into a disregarded entity under the check-the-box regulations. Also assume that the U.S. LLC licenses certain intellectual property to its Norwegian parent, which in turn sublicenses such property to the United States. (See diagram 3.)

Under the Proposed Regulations, the disregarded U.S. LLC would be treated as a person and the back-to-back license arrangement would be characterized as a conduit financing arrangement. Therefore, the IRS would have the ability to disregard the participation of the Norwegian company and recharacterize the transaction as a transaction directly between the U.S. sub-licensee and the disregarded U.S. LLC.

At first glance it would appear that no U.S. withholding tax would be required in this situation on any royalties paid from the United States to Norway because, under the Proposed Regulations, the IRS could disregard the participation of the Norwegian entity and treat the royalties as being paid directly from the United States to the U.S. LLC, which is treated as a person. Unfortunately, for taxpayers this would not be the end result, because the U.S. LLC would be treated as a disregarded entity for all other purposes (other than for purposes of the Proposed Regulations). Therefore, if the IRS were to recharacterize the transaction as a transaction directly between the U.S. sub-licensee and the disregarded U.S. LLC, the royalties would be treated as being paid directly from the United States to the Norwegian company for all other income tax purposes (because the U.S. LLC is a disregarded entity for all other income tax purposes).

Under the Section 894(c) regulations, however, the royalties would not be eligible for reduced withholding tax rates under the U.S.-Norway income tax treaty because they would not be "derived" by a resident of Norway for purposes of such treaty. In particular, Regulation Section 1.894-1(d)(1) provides:

The tax imposed by sections 871(a) [and] 881(a)...on an item of income received by an entity, wherever organized, that is fiscally transparent under the laws of the United States and/or any other jurisdiction with respect to an item of income shall be eligible for reduction under the terms of an income tax treaty to which the United States is a party only if the item of income is derived by a resident of the applicable treaty jurisdiction. For this purpose, an item of income may be derived by either the entity receiving the item of income or by the interest holders in the entity or, in certain circumstances, both. An item of income paid to an entity shall be considered to be derived by the entity only if the entity is not fiscally transparent under the laws of the entity's jurisdiction...An item of income paid to an entity shall be considered to be derived by the interest holder in the entity only if the interest holder is not fiscally transparent in its jurisdiction with respect to the item of income and if the entity is considered to be fiscally transparent under the laws of the interest holder's jurisdiction with respect to the item of income...
As noted above, Section 894(c) would deny treaty benefits in this situation because the royalties would be treated as being paid directly to the U.S. LLC, which is fiscally transparent under the laws of the United States but not under the laws of Norway. Therefore, the Proposed Regulations would cause the royalties to be subject to a 30 percent withholding tax in the United States.37

Use of Finance Branches to Circumvent the Conduit Financing Regulations

While the Proposed Regulations are clearly designed to shut down conduit financing arrangements involving hybrid entities (i.e., entities that are fiscally transparent for U.S. tax purposes but non-fiscally transparent for foreign tax purposes), the Proposed Regulations do not prevent taxpayers from obtaining treaty benefits when a non-hybrid branch is utilized. This is because the Proposed Regulations specifically indicate that only entities that are disregarded under the check-the-box regulations are treated as persons for purposes of determining whether a conduit financing arrangement exists.

For example, several jurisdictions that have treaties with the United States, such as Hungary, Norway, Poland and Spain, have treaties with jurisdictions such as Switzerland and Luxembourg, both of which have very favorable finance branch regimes that offer a significantly reduced tax rate on interest income.38 A finance branch registered in Switzerland or Luxembourg typically will be subject to an effective tax rate ranging from 2 to 4 percent, and a ruling can be obtained in these jurisdictions in this regard.39  Accordingly, by having a Hungarian, Norwegian, Polish or Spanish company operate a finance branch in either Switzerland or Luxembourg, and by allocating any loans and the related interest to such finance branch, rather than the "home office," the foreign income tax imposed on the receipt of the interest can be reduced significantly.40

Under such a structure, any income derived by the finance branch (which, effectively, is a permanent establishment) in Switzerland or Luxembourg41 will be exempt from corporate income tax in the "home office" (i.e., in Hungary, Norway, Poland or Spain) under the respective non-U.S. income tax treaties.42 Moreover, unlike many of the newer U.S. income tax treaties (including the recent protocols with Belgium, Denmark, Finland and Germany), the U.S. income tax treaties with Hungary, Norway, Poland and Spain have no "anti-triangular" provisions. In general, the purpose of such a provision is to prevent a non-U.S. taxpayer from claiming treaty benefits if the income received by the non-U.S. treaty party is attributed to a permanent establishment located in a third jurisdiction and the combined rate of tax in both the jurisdiction of the home office and the permanent establishment does not exceed a certain percentage.

For example, Article 24(4) of the U.S.-Switzerland Income Tax Treaty provides as follows:

Notwithstanding the provisions of paragraphs 1 through 3, where an enterprise of a Contracting State derives income from the other Contracting State, and that income is attributable to a permanent establishment which that enterprise has in a third jurisdiction, the tax benefits that would otherwise apply under the other provisions of the Convention will not apply to any item of income if the combined tax that is actually paid with respect to such income in the first-mentioned State and in the third jurisdiction is less than 60% of the tax that would have been payable in the first-mentioned State if the income were earned in that State by the enterprise and were not attributable to the permanent establishment in the third jurisdiction. Any dividends, interest or royalties to which the provisions of this paragraph apply shall be subject to tax at a rate that shall not exceed 15% of the gross amount thereof.
Therefore, as a result of the favorable income tax treaties concluded between the respective foreign jurisdictions (which exempt from corporate income tax in the home office any income attributed to a permanent establishment in the other jurisdiction), the lack of an anti-triangular provision in the U.S. income tax treaties, and the fact that the Proposed Regulations only apply to disregarded entities under the check-the-box regulations,43 this structure allows a non-U.S. taxpayer to take advantage of the reduced withholding tax rates on interest under several U.S. income tax treaties and substantially reduce the foreign corporate income tax by allocating the interest to a low-tax finance branch.44

The Proposed Regulations and Satisfying the Base Erosion Test

Another interesting issue that arises by virtue of the Proposed Regulations is as follows: If it is determined that a conduit financing arrangement does not exist because, for example, the intermediate entity performs significant financing activities with respect to the financing transactions forming part of the financing arrangement to which it is a party, is how a payment made to a disregarded entity would be treated for purposes of the "base erosion" test under a particular treaty's LOB provision. As noted earlier, one of the manners in which a corporate resident of a treaty country can satisfy the treaty's LOB provision is if (i) on at least half the days of the taxable year, at least 50 percent of each class of shares in the corporation is owned, directly or indirectly, by residents of the jurisdiction where the corporation is formed; and (ii) not more than 50 percent of the gross income of the foreign corporation is paid or accrued, in the form of deductible payments, to "persons" who are residents of the United States or residents of the jurisdiction where the corporation is formed (i.e., the base erosion test). Furthermore, under the base erosion test contained in a number of the LOB provisions, the issue of whether a deductible payment is made to a person is determined by looking to the laws of the source country (i.e., the United States) rather than the residence country.45

For example, assume a back-to-back loan arrangement is in place where a company organized in Austria wholly owns a Cayman entity that is disregarded under the check-the-box regulations, and the Cayman company advances money to the Austrian company, which in turn advances money to the United States. Also assume that it is determined that such arrangement does not constitute a conduit financing arrangement because, for example, the Austrian entity performs "significant financing activities." In this scenario, the question is whether the second leg of the interest payments made from the Austrian corporation to the disregarded Cayman entity would be considered a deductible payment made to a "person" under the U.S.-Austrian income treaty.

Similar to most U.S. income tax treaties, the U.S.-Austrian income tax treaty defines the term "person" to include an "individual, an estate, a trust, a company and any other body of persons."46 Moreover, the term "company" means "any body corporate or any entity which is treated as a body corporate for tax purposes."47 Because the meaning of these terms is not entirely clear, and the goal of this structure is to obtain reduced U.S. withholding tax rates under the U.S.-Austria income tax treaty, it is necessary to look to U.S. law to determine whether a disregarded entity is treated as a "person" for purposes of satisfying the base erosion test.48

The Proposed Regulations clearly indicate that an entity that is disregarded under the check-the-box regulations would constitute a person. As noted earlier, however, recently issued proposed regulations under Section 901, as well as current regulations under 1441, provide otherwise.49 Furthermore, if it is determined that the Proposed Regulations are not applicable because, for example, a back-to-back loan arrangement does not constitute a conduit financing arrangement, it would seem that the general treatment of disregarded entities would apply, and therefore, the interest payment from the Austrian corporation to the disregarded Cayman entity would not be treated as a deductible payment to a person for purposes of the treaty. Thus, the payment arguably should not be taken into account in determining whether the base erosion test is satisfied. Until further guidance is issued, however, it would be difficult for a taxpayer to get comfortable with this issue either way.

Possible Expansion of Regulations to Hybrid Instruments

As previously noted, the Proposed Regulations are currently limited to treating disregarded entities under the check-the-box regulations as persons for purposes of determining whether a conduit financing arrangement exists. Nevertheless, the Preamble indicates that the IRS and Treasury are continuing to study conduit financing arrangements and may issue separate guidance to address the treatment of certain hybrid instruments.

The Treasury Department and IRS are studying transactions in which a financing entity advances cash or other property to an intermediate entity in exchange for a hybrid instrument that is treated as debt under the laws of the foreign jurisdiction where the intermediate entity is resident and is not treated as debt for U.S. federal tax purposes. According to the Preamble, the issue under consideration is whether such instruments should constitute a financing transaction and part of a financing arrangement. The Preamble also indicates that no inference should be drawn regarding the treatment of such instruments under current law, including judicial doctrines with respect to conduit financing transactions.

According to the Preamble, one possible approach is to treat all transactions involving such hybrid instruments between a financing entity and an intermediate entity as financing transactions. The IRS and Treasury are requesting comments on this issue, including whether and to what extent a connection or relationship between the issuer and recipient of the hybrid instrument (for example, an equity ownership percentage) should be required in order to treat such instruments as financing transactions.

Another possible approach, according to the Preamble, is to add additional factors to consider in determining when stock in a corporation (or other similar interest in a partnership or trust) may constitute a financing transaction. These factors would focus on whether, based on the facts and circumstances surrounding the stock (or other similar interest in a partnership or trust), the financing entity had sufficient legal rights to, or other practical assurances regarding, the payment received by the intermediate entity to treat the stock as a financing transaction, and might include the following: (i) intent of the parties to pay all or substantially all payments received by the intermediate entity to the financing entity; (ii) history of payment of amounts received by the intermediate entity to the financing entity; and (iii) precedence of the obligees over other creditors regarding the payment of interest and principal, currently or in bankruptcy.
 
Conclusion

The check-the-box regulations originally were issued to promote certainty when making the determination of whether an unincorporated association should be treated as either a corporation or a partnership for federal tax purposes. Despite this intent, the IRS and Treasury continue to issue guidance that attempts to do away with this certainty by treating disregarded entities as regarded entities for limited U.S. federal income tax purposes. While still in proposed form, the Proposed Regulations represent another example of a piecemeal approach that is clearly focused on preventing taxpayers from affirmatively using the check-the-box regulations to secure tax benefits that were never intended when they were drafted.



1 Treas. Reg. Sections 301.7701-1, -2, and -3. All references to "Section" refer to Sections of the Internal Revenue Code (the Code) of 1986, as amended, and the Treasury Regulations promulgated thereunder.

2 See the preamble to the Proposed Regulations.

3 REG-113909-98. The proposed hybrid branch regulations were not to be effective until five years after they were finalized. Prop. Treas. Reg. Section 1.954-9(c)(1).

4 REG-110385-99.

5 In Notice 2003-46, 2003-2 C.B. 54, the IRS announced its intention to withdraw the proposed extraordinary transaction regulations in response to the concern that they were "overly broad" and would "mitigate the increased certainty promoted" by the final check-the-box regulations. In fact, in Dover v. Commissioner, 122 T.C. 324 (2004), the Tax Court held that the filing of a check-the-box election immediately prior to a controlled foreign corporation's sale of the stock of a foreign subsidiary would be respected as a sale of the underlying assets of the foreign subsidiary rather than a sale of the stock in such foreign subsidiary. For a detailed discussion of this case, see Jeffrey L. Rubinger, "Tax Court Upholds 'Check and Sell' Strategy to Avoid Subpart F Income," 101 Journal of Taxation 20 (July 2004).

6 Prop. Treas. Reg. Section 1.881-3(f).

7 Sections 871(a) and 881(a).

8 Section 871(b) and 882(a).

9 See Article 4(1) of the U.S.-Netherlands income tax treaty.

10 It should be noted that under a number of U.S. income tax treaties, the ownership test is not limited to residents of the particular jurisdiction where the company is formed. Rather, both U.S. citizens and residents are treated as "qualified residents" as well for purposes of this test.

11 See Article 16(1)(d) of the U.S.-Austria income tax treaty.

12 See also Rev. Ruls. 84-152, 1984-2 C.B. 381; 84-153, 1984-2 C.B. 383; and 87-89 1987-2 C.B. 195 (situations 1 and 2), all of which involved back-to-back loan arrangements and declared obsolete by Rev. Rul. 95-56, 1995-2 C.B. 322 after the issuance of the final conduit financing regulations.

13 It should be noted that the Tax Court in SDI Netherlands v. Commissioner, 107 T.C. 161 (1996), rejected the rationale of Rev. Rul. 80-362 and did not impose U.S. withholding tax in a back-to-back licensing arrangement.

14 Treas. Reg. Section 1.881-3(a)(1).

15 Treas. Reg. Section 1.881-3(a)(2)(i)(A).

16Id.

17 Treas. Reg. Section 1.881-3(a)(2)(ii)(A).

18 Treas. Reg. Section 1.881-3(a)(2)(ii)(B). For purposes of this provision, a person will be considered to have a right to cause a redemption or payment if the person has the right (other than rights arising, in the ordinary course, between the date that a payment is declared and the date that a payment is made) to enforce the payment through a legal proceeding or to cause the issuer to be liquidated if it fails to redeem the interest or to make a payment. A person will not be considered to have a right to force a redemption or a payment if the right is derived solely from ownership of a controlling interest in the issuer in cases where the control does not arise from a default or similar contingency under the instrument. The person is considered to have such a right if the person has the right as of the issue date or, as of the issue date, it is more likely than not that the person will receive such a right, whether through the occurrence of a contingency or otherwise. Treas. Reg. Section 1.881-3(a)(2)(ii)(B)(2).

19 Treas. Reg. Section 1.881-3(a)(3)(ii)(A).

20 Treas. Reg. Section 1.881-3(a)(3)(ii)(C).

21 Id.

22 Id.

23 Treas. Reg. Section 1.881-3(a)(4)(i).

24 Treas. Reg. Section 1.881-3(b)(1).

25 Treas. Reg. Section 1.881-3(b)(2).

26 Treas. Reg. Section 1.881-3(b)(3).

27 Treas. Reg. Section 1.881-3(b)(3)(ii)(A).

28 Treas. Reg. Section 1.881-3(b)(3)(ii)(B).

29 Treas. Reg. Section 301.7701-3(b)(1).

30 Treas. Reg. Section 301.7701-3(b)(2).

31 Treas. Reg. Section 301.7701-2(a).

32Prop. Reg. Section 1.881-3(a)(2)(i)(C). It is interesting to note that this position is inconsistent with recently issued proposed regulations in the international area in which a disregarded entity was specifically not characterized as a "person" for U.S. federal income tax purposes. See Regulation Section 1.1441-1(c)(8) and Prop. Treas. Reg. 1.901-2(f)(1)(i). See also TAM 200807015 (Nov. 7, 2007), in which the IRS stated that a foreign disregarded entity was not treated as a "person" for foreign tax credit purposes.

33While the example does not contain enough facts, it is assumed that the interest paid would not be eligible for the portfolio interest exemption from U.S. withholding tax. See Sections 871(h) and 881(c).

34See footnote 31.

35See Regulation Section 1.894-1(d)(1) and the subsequent discussion in the text of the article for a more detailed analysis of this regulation.

36Again, this assumes that the portfolio interest exemption would not be available. Furthermore, if the transaction is recharacterized as a transaction directly between DS and FS, treaty benefits would not be available under the DS-FP income tax treaty because the interest would not be "derived" by FP for purposes of Section 894(c), even though it is treated for, U.S. federal income tax purposes, as being paid directly to FP (because FS is a disregarded entity). See Treas. Reg. Section 1.894-1(d).

37The IRS also has broad authority under the conduit financing regulations to challenge a taxpayer's position that the form of its transaction should be ignored for U.S. federal income tax purposes. The regulations provide that "[a] taxpayer may not apply this section to reduce the amount of its Federal income tax liability by disregarding the form of its financing transactions for Federal income tax purposes or by compelling the district director to do so." Treas. Reg. Section 1.881-3(a)(3)(ii)(E)(2)(iii).

38In general, the finance branch will be responsible for the administration of the loans.

39For a good discussion of the requirements necessary to qualify for the favorable Swiss finance branch tax rate, see Widmer and Blom, "Reviving the Swiss Branch Concept," Int'l Tax Rev. (May, 2000); see also Zoetmulder and Fiszer, "Tax Planning in the New E.U. Countries: Poland," Tax Planning Int'l--European Union Focus (Dec. 2004/Jan. 2005) for a discussion of the use of Swiss and Luxembourg finance branches in connection with the interest provision under the U.S.-Poland Income Tax Treaty.

40With respect to Norway, the structure would only work with a Luxembourg finance branch, not a Swiss finance branch. This is because of the newly enacted protocol between Norway and Switzerland under which income allocated to a Swiss permanent establishment will no longer be exempt from corporate income tax in Norway. See Article 8 of the 2005 Protocol to the 1987 Norway-Switzerland Income Tax Treaty. Similarly, with respect to Spain, the structure would only work with a Swiss finance branch, not a Luxembourg finance branch.

41See, however, the preceding footnote, indicating the planning opportunity with Norway is limited to a Luxembourg finance branch, and the planning opportunity with Spain is limited to a Swiss finance branch.

42See Article 23(1)(a) of the Hungary-Switzerland Income Tax Treaty; Article 24(1)(a) of the Hungary-Luxembourg Income Tax Treaty; Article 23(1)(a) of the Poland-Switzerland Income Tax Treaty; Article 24(2)(a) of the Poland-Luxembourg Income Tax Treaty; Article 23(1) of the Norway-Luxembourg Income Tax Treaty, and Article 23(1) of the Spain-Switzerland Income Tax Treaty. It also may be possible to have a Polish company organize a UAE finance branch, as any income allocated to such a branch will be exempt from tax in Poland under the Poland-UAE Income Tax Treaty and the UAE has no income tax. See Article 24(1)(a) of the Poland-UAE Income Tax Treaty.

43While the debt allocated to the finance branch should not be treated as a financing transaction, it is possible that the stock of the foreign corporation could be treated as a financing transaction if the corporation is required to redeem the stock of it shareholders at a specified time or the shareholders have the right to require the corporation to redeem the stock. See footnote 17, supra.

44The use of this structure is even more advantageous when the U.S. income tax treaties with Hungary, Norway or Poland are utilized because none of these treaties currently contains an LOB provision. For a more detailed discussion of planning opportunities available with U.S. income tax treaties without LOB provisions, see Jeffrey L. Rubinger, "Tax Planning with U.S. Income Tax Treaties Without LOB Provisions," 36 Tax Management International Journal No. 3 (March 9, 2007).

45It is important to note that, under several of the recently enacted treaties and protocols concluded by the United States, such as those entered into with Belgium, Denmark, Finland and Germany, as well as the 2006 U.S. Model Income Tax Treaty, the issue of whether a deductible payment is made to a person is determined by looking to the laws of the residence (i.e., foreign) country rather than the laws of the source country (i.e., the United States). As a result, this issue would not arise when a deductible payment is made to an entity that is disregarded under the check-the-box regulations under the base erosion test contained in one of these treaties.

46Article 3(1)(a) of the U.S.-Austrian income tax treaty.

47Article 3(1)(b) of the U.S.-Austrian income tax treaty.

48See Article 3(2) of the U.S.-Austrian income tax treaty. See also PLR 200712007 (November 30, 2006), PLR 200626009 (March 9, 2006), and PLR 200522006 (March 4, 2005), which entail claims for treaty benefits where disregarded entities are involved, in which the IRS indicated that it is necessary to look to the local law of the jurisdiction granting treaty benefits to determine the meaning of an undefined term under the treaty.

49See footnote 31, supra.