GT Alert

Proposed Regulations Regarding Certain Disregarded Entities May Provide Useful Authority in Treaty Interpretation

April 2004
By Fred Adam, Greenberg Traurig, Silicon Valley Office

  View or download the PDF version of this Alert here.

On March 31, the Internal Revenue Service issued proposed regulations (REG-106681-02) that would treat disregarded entities as separate entities for any taxes owed by either the disregarded entity or by another entity for which the disregarded entity is liable.

Types of Disregarded Entities

"Thus, should the proposed regulations be finalized such regulatory authority could be argued in such jurisdictions to support the position that at least single member LLCs (disregarded entities) are U.S. residents for treaty purposes..."

The rules would apply to the following three types of entities that may be disregarded as an entity separate from their owner: a qualified real estate investment trust subsidiary, a qualified subchapter S subsidiary (QSub), and an eligible single owner entity. The tax code mandates that a QSub be disregarded, while a qualified REIT subsidiary and an eligible single owner entity may choose to be disregarded or treated as a taxable corporation. The effective date for the regulations are proposed to apply on or after April 1, 2004. This Alert focuses on eligible single owner entities that are not QSubs or qualified REIT subsidiaries, and that are disregarded for U.S. federal income tax purposes.

Under §301.7701-3(b)(1) and (2), an eligible entity with a single owner may be disregarded as an entity separate from its owner. Section 301.7701-3(b)(1)(ii) provides that a domestic eligible entity with a single owner is disregarded unless the entity makes an election to be classified as an association (and thus a corporation under §301.7701-2(b)(2)). Section 301.7701-3(b)(2)(C) provides that a foreign eligible entity with a single owner that does not have limited liability is disregarded unless the entity elects to be classified as a corporation. Under §301.7701-3(c), a single owner eligible entity that has elected to be treated as a corporation and a foreign eligible entity with a single owner that has limited liability (that would otherwise be treated as a corporation under §301.7701-3(b)(2)(i)(B)) may elect, subject to certain limitations, to be disregarded.

A taxable entity may become disregarded in a variety of circumstances. For example, it is possible for a disregarded entity to be the survivor of a merger of a taxable entity (for example, a corporation) and the disregarded entity. Although a disregarded entity generally is not liable for Federal tax liabilities of its owner with respect to taxable periods during which it is disregarded, the disregarded entity may be liable for Federal taxes with respect to taxable periods during which it was not disregarded or because it is the successor or transferee of a taxable entity.

The proposed regulations do not address the question of whether the disregarded entity is, in fact, either liable for Federal taxes or entitled to a refund or credit of Federal tax. Rather, the regulations clarify that if a disregarded entity is liable for Federal taxes, the disregarded entity will be treated as an entity separate from its owner for purposes of those liabilities, such that assessment may be made against the disregarded entity, the assets of the disregarded entity may be subject to lien and levy, and the disregarded entity may consent to extend the period of limitations on assessment. In addition, the regulations clarify that if a disregarded entity is entitled to a refund or credit of Federal tax, the disregarded entity will be treated as an entity separate from its owner for purposes of that refund or credit.

Practice and Planning Significance

One apparent immediate benefit from the proposed regulations relates to various Treaties, Conventions and Protocols that the United States has with several tax treaty partners, in particular, Australia, Mexico, Spain, Germany, Canada and others. (A recent development regarding Germany that could also bear on this issue from a German perspective is discussed further below). The issue is that these jurisdictions do not recognize an LLC as a U.S. resident for treaty purposes because an LLC is not itself subject to tax in the United States.

For instance, the Canada-U.S. Protocol, the residence article, Article IV (See Article III, 1995 Protocol for current version), provides, in pertinent part:

“For the purposes of this Convention, the term ‘resident’ of a Contracting State means any person that, under the laws of that State, is liable to tax therein by reason of that person’s domicile, residence, citizenship, place of management, place of incorporation or any other criterion of a similar nature, but in the case of an estate or trust, only to the extent that income derived by the estate or trust is liable to tax in that State, either in its hands or in the hands of its beneficiaries.”

Further, Article III, general definitions, provides in pertinent part:

“(e) The term ‘person’ includes an individual, an estate, a trust, a company and any other body of persons;

(f) The term ‘company’ means any body corporate or any entity which is treated as a body corporate for tax purposes;”

Revenue Canada thus takes the position, for instance, that if a U.S. LLC that acts as a holding company of Canadian shares (assume 100% is owned) transfers such Canadian shares in an internal reorganization or other U.S. non-recognition transaction, that transfer will trigger a taxable capital gain in Canada because the LLC is not a U.S. resident for treaty purposes (otherwise gain, if any, would only be taxable in the U.S. if the LLC were treated as a resident). As stated above, Spain, Mexico, Australia, Germany and a couple others also take this position (certain filings can be made to obtain a U.S. residency certificate that should grant treaty protection in these jurisdictions but this has not been validated in all countries).

Thus, should the proposed regulations be finalized such regulatory authority could be argued in such jurisdictions to support the position that at least single member LLCs (disregarded entities) are U.S. residents for treaty purposes (without seeking a resident certificate). In the meantime, however, the proposed regulations are the position of the U.S. Treasury and as such do support the position that a disregarded entity should be respected as a U.S. resident for treaty purposes. Of course, for the subset of U.S. LLCs that are not disregarded entities the residence issue may continue to be problematic. However, as mentioned above with regard to Germany, Germany has recently issued guidance addressing entity classification of U.S. LLCs. Although the guidance does not address the German classification rules in the treaty context discussed herein, the guidance does suggest that the tide may be changing in some jurisdictions as foreign tax authorities come to understand LLCs better. In short, it may take a specific exception in future treaties/protocols/conventions to fully address the resident status of a multi-member U.S. LLC, but proposed regulations like those discussed herein may be helpful in the interim.

© 2004 Greenberg Traurig

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