Proposed check-the-box regulations under Section 7701.

On August 9, 1996, Tax Executives Institute submitted the following comments to the Internal Revenue Service concerning its proposed regulations under section 7701, relating to the simplification of the Internal Revenue Code's entity classification rules. The Institute's comments were prepared under the aegis of its International Tax Committee, whose chair is Joseph S. Tann, Jr. of Ameritech Corporation. The following members of the Institute also participated in the development of the Institute's submission: Lester D. Ezrati of Hewlett-Packard Company, Melody L. Johnson of Mission Energy Co., Richard S. Michaels of Goodyear Tire & Rubber Co., Susan M. Murray of ENRON Oil & Gas Company, and Lisa Norton of Ingersoll-Rand Company

On May 9, 1996, the U.S. Department of the Treasury and the Internal Revenue Service issued proposed regulations under section 7701 of the Internal Revenue Code, relating to the simplification of the entity classification rules. The proposed regulations were published in the Federal Register on May 9, 1996 (61 Fed. Reg. 21989) and in the Internal Revenue Bulletin on June 10, 1996 (1996-24 I.R.B. 20).

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our 5,000 members represent more than 2,700 of the leading corporations in the United States and Canada. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations under section 7701 of the Internal Revenue Code, relating to the simplification of the entity classification scheme.

TEI commends the IRS and Treasury for issuing these proposed "check-the-box" regulations. Although the current regulations may have made some sense when they were issued three decades ago, in today's global economy taxpayers and the government alike expend far too many resources in addressing entity classification issues. The proposed regulations set forth a regime that is clear, certain, and simple -- without sacrificing any legitimate tax policy goals. Thus, we strongly agree that "it is appropriate to replace the increasingly formalistic rules under the current regulations with a much simpler approach that is generally elective." 1996-24 I.R.B. at 21.

Moreover, as the proposed regulations recognize, the need for a clear and predictable classification system is not limited to the domestic area. Thus, the Institute also agrees that it is appropriate to extend the regulatory scheme into the international arena. We urge the government to move swiftly to issue final regulations this year.

Prop. Reg. [sections] 301.7701-2: Definitions

A. Per Se List of Foreign Corporations. Prop. Reg. [sections] 301.7701-2(b) generally defines "corporation" to include any business entity recognized for federal tax purposes that is organized under a federal or state statute. In the international area, subparagraph (8) provides that the term "corporation" includes 82 listed foreign entities, such as a Canadian corporation or a French societe anonyme. The preamble states that the organizations listed are "limited liability entities" and invites comments on the composition of the list. 1996-24 I.R.B. at 22.

TEI believes that there are several practical problems that need to be addressed in respect of the per se list. What is the process by which the list was developed? Will it be kept up-to-date and, if so, how often will it be issued? Will future additions or deletions be subject to a notice-and-comment period?

More fundamentally, TEI believes there needs to be some mechanism to monitor changes in foreign statutes and to receive taxpayer input on entities to be removed from the list. For example, if France changed the legal requirements for establishing a societe anonyme, would taxpayers be able to rely on the list until the IRS formally modified the list? We assume the answer is, yes. If not, the certainty promised by the simplified classification scheme will vanish.

B. Specific Entities Included on the Per Se List. The list includes several entities that TEI submits should not be considered per se corporations. For example, the list includes a corporation formed in Canada. It is unclear whether this designation includes entities organized under Canadian provincial law. If so, an issue arises concerning the status of a Nova Scotia unlimited liability company. Nova Scotia does not define a "company" as a corporation, but the term appears at least once in the Nova Scotia Companies Act. In Private Letter Ruling 9538020 (June 22, 1995), the IRS ruled that such a company may qualify as a partnership under U.S. law. TEI recommends that the reference to Canadian corporation be clarified to exclude such companies.

Similarly, the per se list includes the Indonesian Perseroan Terbatas (PT), which is the only entity available for foreign investment in Indonesia. There are two types of PTs in Indonesia: an "open" PT and a "closed" PT. The open PT is a publicly held company that is subject to the capital markets law requiring at least 300 shareholders and paid-up capital of at least 3 billion rupiah. In contrast, the closed PT has no such requirements for the number of shareholders or the amount of paid-up capital. TEI believes that only the open PT should be included in the list of per se corporations.

The list also includes an Indian public limited company. Under Indian law, a private limited company in some circumstances can be deemed to be a public company. For example, if a private company's revenues exceed 100 million rupees (approximately $3 million) for three consecutive years, it will be deemed to be a public company under section 43A of the Companies Act. It is TEI's belief that it is inappropriate to consider an entity a public corporation merely because its revenues exceed a certain amount. Prop. Reg. [sections] 301.7701-2(b)(8) should be revised to provide an exclusion from per se corporate status for an Indian public limited company that is deemed to be a public company solely by virtue of section 43A of the Companies Act.

Prop. Reg. [subsections] 301.7701-2(d) & (e)(2): Transition Rules and Effective Date

Prop. Reg. [sections] 301.7701-2(d) provides a special exception from per se corporate status for certain foreign business entities that were in existence on the date the proposed regulations were issued. This grandfather rule permits partnership status for entities that meet the following requirements --

* The entity was in existence and claimed to be a partnership on May 8, 1996, and for all prior periods;

* That classification was relevant to any person for federal tax purposes at any time during the period that included May 8, 1996;

* The entity had a reasonable basis (within the meaning of section 6662) for claiming partnership classification; and

* Neither the entity nor any member has been notified in writing on or before May 8, 1996, that the classification of the entity is under examination.

Prop. Reg. [sections] 301-7701-3(e)(2) similarly provides that an entity's claimed classification will be respected for all periods prior to the effective date of the regulations if the entity had a reasonable basis for its claimed classification; the entity claimed that same classification for all prior periods; and neither the entity nor any member had been notified that the issue was under examination.

TEI agrees that reasonable transition rules are necessary to prevent dislocations. Several issues are raised, however, by the language of the special rule and the effective date provisions.

A. "For All Prior Periods." The rule requires that the grandfathered entity must have been in existence and claimed to be a partnership "for all prior periods." Consider the following example:

A Swiss societe anonym is established in 1960. The taxpayer treats the entity as a corporation from the date of inception to 1993. In 1993, the organizational documents of the entity are changed and the changes provide the members with a reasonable basis under the current section 7701 regulations to treat the entity as a partnership.

Under the proposed regulations, the Swiss SA arguably would not be entitled to grandfather treatment because it had not been treated as a partnership for all prior periods. The better view, however, is that the change in the organizational documents creates a new entity with respect to which the "all prior periods" test must be applied. So long as a reasonable basis exists for treating the entity as a partnership, there is no sound policy reason for denying such treatment to the Swiss SA in the above example.

Moreover, we suggest that prior periods that are not relevant for federal tax purposes should be eliminated from consideration. Thus, we recommend that Prop. Reg. [sections] 301.77012(d)(1) be amended to read, as follows:

The entity was in existence and claimed to be a partnership on May 8, 1996, and for all prior periods for which this classification is relevant for federal tax purposes;

B. Entities Disregarded as Separate. The special rule provides that an entity historically treated as a partnership may retain that status, even though it is included in the per se list of corporations. The ability of an entity to retain its historic, pass-through treatment under the transition rules should not depend on the number of its shareholders. There is adequate support under current law for classifying single-owner entities as branches. See Hynes v. Commissioner, 74 T.C. 1266 (1980); Barnette v. Commissioner, TCM 1992-371; General Counsel Memorandum 39395 (Aug. 5, 1985), and Private Letter Ruling 8852017 (Sept. 27, 1988). Thus, Prop. Reg. [subsections] 301.7701-2(d) and 301.7701-3(e)(2) should be amended to include such entities.

C. Entities Formed in the Interim. It is unclear what happens to entities on the per se list that are formed after May 8, 1996 -- when the regulations were proposed -- and before the regulations become final. Taxpayers in such circumstances are left in limbo: They cannot check-the-box, but they don't know whether the entities will be treated as corporations because the list may change after the comment period. Given the proposed regulations' departure from the IRS's longstanding position on classification of foreign entities and the need to refine the list itself, see, e.g, Rev. Rul. 88-8, 1988-1 C.B. 403, a more reasonable approach is either to change the May 8, 1996, date to the date final regulations are issued or to craft a transition rule akin to a binding contract exception.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on the proposed regulations under section 7701 of the Code. If you have any questions, please do not hesitate to call Joseph S. Tann, Jr., chair of TEI's International Tax Committee, at [phone] or Mary L. Fahey of the Institute's professional staff at [phone].