International Tax Entity Classification Basics
One of the most important building blocks for any business is selecting the correct legal and tax entity type. The choice of entity classification can make all the difference when it comes to liability protection and optimizing tax outcomes, so it’s no surprise that this decision takes on a new form when thrown into the arena of international tax.
An entity can elect to be taxed as a corporation, a partnership, or a disregarded entity. Of these, a corporation is responsible for paying tax on its taxable income, while the other two classifications’ tax is paid by the entity’s owner or shareholder. These types of entities are called “pass-through” or “transparent” entities because their tax attributes pass through them to their owners. The election is made on IRS Form 8832 – known as a “check the box” election.
If no action is taken, a default classification applies to a new tax entity. The IRS maintains a list of certain foreign entities that are considered per se corporations—entities that are by definition considered to be a corporation. If a wholly foreign entity is a corporation for U.S. tax purposes, the entity may be able to defer U.S. tax on its income indefinitely. However, when the money is distributed back to the company’s U.S. owner(s), it will be taxed at that time.
On the other hand, if a foreign entity is a pass-through for U.S. tax purposes, the U.S. individual owners will pay U.S. tax on their income every year as it is earned. They will, however, be able to take a foreign tax credit to the extent the company has paid income tax to the other country, and they will be free to bring the profits from the foreign entity into the U.S. with no additional income tax. U.S. C corporation owners of foreign corporations are eligible for foreign tax credits regardless of the foreign entity treatment.
Hybrid (or Reverse Hybrid) Entity
A simple explanation of a hybrid entity is that it is a company which is taxed as a different type of entity in one country than another. For example, a company that is taxed as a corporation in a foreign country could be treated as a partnership for U.S. tax purposes. This would result in a hybrid entity, which pays its own tax in a foreign country, but in the U.S. its tax attributes (incomes and deductions) flow to its owner, who then pays the tax. A reverse hybrid entity would be just the opposite—treated as a flow-through entity in a foreign country and a corporation in the U.S.
A multinational intergovernmental organization known as the Organization for Economic Co-operation and Development (OECD) has targeted hybrid entities and hybrid transactions as an international tax planning tool. Under their Base Erosion and Profit Shifting (BEPS) framework, the OECD has targeted “hybrid mismatch transactions” with a set of recently released recommendations designed to make it harder for companies to take advantage of many of the most favorable tax planning opportunities.
A properly planned corporate structure using hybrid entities could create advantageous tax situations that result in certain transactions being deducted in multiple countries. This structure could also maximize foreign tax credits and enable the entity to avoid paying taxes in countries with higher tax rates. A poorly planned structure could result in income being taxed multiple times, lost deductions, wasted foreign tax credits and the loss of benefits from tax treaties between nations.
Whether it’s your business’ first foreign subsidiary, or you have multiple foreign operating entities, each new venture should be analyzed by an international tax professional to make sure that you’re achieving an optimal tax outcome.