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Comments on changes in entity classification: special rule for certain foreign eligible entities.

April 4, 2000

On April 4, 2000, Tax Executives Institute submitted the following comments on the proposed regulations under section 7701 of the Internal Revenue Code, relating to certain transactions that occur within a specified period of time before or after a change in entity classification. The comments were submitted under the aegis of the Institute's International Tax Committee, whose chair is Michael P. Boyle of Microsoft Corporation.

On November 26, 1999, the Internal Revenue Service issued proposed regulations (REG-110385-99) under section 7701 of the Internal Revenue Code, relating to certain transactions that occur within a specified period of time before or after a change in entity classification. The proposed regulations were published in the November 29, 1999, issue of the Federal Register (68 Fed Reg. 66591) and in the December 13, 1999, issue of the Internal Revenue Bulletin (1999-50 I.R.B. 670). A hearing on the regulations was held on January 31, 2000. Tax Executives Institute is pleased to provide the following comments on the proposed rules. For simplicity's sake, the proposed regulations are referred to as the "proposed regulations"; specific provisions are cited as "Prop. Reg. [sections]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin.


Tax Executives Institute is the principal association of corporate tax executives in North America. TEI has 5,000 individual members who represent more than 2,800 of the leading corporations in the United States, Canada, and Europe. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and, because it provides certainty, that taxpayers can comply with in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. 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.

The Check-The-Box Regime

On December 18, 1996, the IRS and Treasury Department issued final regulations relating to the classification of business organizations under section 7701 of the Code. The so-called check-the-box regulations replace the formalistic entity classification rules with a simpler, elective regime. Designed to ease administrative burdens for taxpayers and the government, the new rules permit taxpayers to elect to treat certain domestic or foreign business organizations as partnerships, corporations, or disregarded entities (e.g., branches) for federal tax purposes. They constitute a bold, innovative approach to resolving the manner in which business entities are classified for tax purposes. The primary benefits of the rules include certainty and a reduction of transaction costs.

In 1997 the IRS and Treasury Department issued the proposed conversion regulations, which addressed the tax consequences resulting from an election to change the tax classification of an eligible entity. These regulations were issued in final form concurrently with the new proposed regulations and provide in Treas. Reg. [sections] 301.7701-3(g) that, when a foreign corporation elects to check the box to be treated as a disregarded entity, it is deemed to have distributed all the corporation's assets and liabilities to its single owner in a liquidation. The transaction is treated as occurring immediately before the close of the day before the election is effective.

The preamble to the proposed regulations acknowledges that taxpayers may attempt to use entities that are disregarded as entities separate from their owners to achieve results that are inconsistent with the policies and rules of particular Code sections or treaties, including the sourcing rules, the foreign tax credit limitations rules, the disposition of ownership interests under Subpart F, and the outbound transfer provisions of section 367. 1999-50 I.R.B. at 670. For this reason, Prop. Reg. [sections] 301.7701-3(h) would revoke the entity's classification as a disregarded entity (and thereby classify the entity as an association taxable as a corporation) in certain circumstances. The special rule applies to "extraordinary transactions" occurring within a period commencing 1 day before and ending 12 months after the date that a foreign entity changed its classification to a disregarded-entity status, provided that the entity had been taxable as a corporation within the 12-month period prior to the extraordinary transaction. "Extraordinary transactions" include the sale, exchange, transfer, or other disposition of a 10-percent or greater interest in the foreign entity in one or more transactions beginning on the day before the classification and ending 12 months later. The special rule would not apply if a taxpayer establishes that the classification as a disregarded entity does not materially alter the tax consequences of the extraordinary transaction. The regulations will become effective on the date final regulations are published in the Federal Register.

A. The Scope of the Proposed Regulations. TEI is concerned about the scope of the proposed regulations, especially in light of the Treasury's self-imposed moratorium on the issuance of hybrid branch regulations. (These regulations are to be effective no earlier than July 2006.) Although the Treasury Department has described the rules as merely narrowing the operational provisions of the check-the-box regime, the regulations more closely resemble an anti-abuse rule of potentially broad scope. The preamble indicates that the rule is aimed at certain targeted transactions, 1999-50 I.R.B. at 670, but the proposed regulations themselves belie that assurance. What is more, the two simple examples provide precious little guidance on the reach of the proposed regulations. Thus, it is difficult to determine the range of transactions covered by the proposed regulations.

Invalidating a taxpayer's check-the-box election retroactively may also have collateral -- and unforeseen -- consequences for the taxpayer and the third-party purchaser. Presumably, the purchaser of the interest in the disregarded entity will be treated as acquiring stock rather than assets. A gain recognition agreement may therefore be required. If a step-up in basis is desired, a section 338 election will be required. Moreover, taxpayers will have to review actions taken after the date the check-the-box election is made and before the extraordinary transaction occurs to determine whether any re-characterization (such as dividend treatment) is needed. In some cases, amended returns may be required to be filed. Such a burdensome approach seems unnecessary, especially when the disposition was not part of a pre-arranged plan.

More fundamentally, TEI questions whether such a special rule is necessary. Common-law principles (such as the step-transaction and substance-over-form doctrines), combined with anti-abuse rules set forth in the section 701 or 865 regulations, are sufficient to address legitimate concerns about the check-the-box regime. The IRS has generally not been shy in invoking these rules. See, e.g., Rev. Rul 2000-12, 2000-11 I.R.B. 1 (relying on the economic substance rule to disallow losses generated by debt straddles); Rev. Rul 99-14, 1999-13 I.R.B. 3 (addressing the lack of economic substance in so-called lease in, lease out real estate arrangements). In addition, section 269 of the Code provides authority for the IRS to challenge certain transactions. Given the vitality of these doctrines, a narrowly circumscribed rule aimed at specific transactions would be more appropriate.

Finally, the regulations assume that any disposition of a 10-percent or more interest in the entity that occurs within a year is part of a preconceived plan. Such a bright-line test could easily ensnare compliant taxpayers, especially given the small (10-percent) threshold for triggering the rules. If the rules are retained, we recommend that the threshold be increased to more than 50 percent -- which would constitute an actual transfer of control.

B. The Exception. Prop. Reg. [sections] 301.7701-3(h)(3) sets forth an exception to the special rule for extraordinary transactions. The rules will not apply if the taxpayer establishes to the satisfaction of the Commissioner that the classification as a disregarded entity "does not materially alter the Federal tax consequences of the extraordinary transaction."

The exception is at once narrow and ambiguous. Utilizing the check-the-box regulations on a routine basis materially alters the federal tax consequences because the transformation of a corporation into a disregarded entity and the subsequent disposition of that entity transforms a disposition of stock into a disposition of assets; the tax consequences of the two transfers differ significantly. Moreover, the exception is vague. No definition of the term "materially alter" is provided nor is any procedure set forth by which the exception can be invoked. TEI believes the exception should be clarified by defining the terms and providing a procedure to permit taxpayers to apply for relief. At a minimum, examples establishing the scope of the exception should be provided.

C. Interaction with the Conversion Regulations. Prop. Reg. [sections] 301.7701-3(h)(1)(i) provides that, "notwithstanding any other provision of this section," a foreign eligible entity that would be classified as a disregarded entity will be classified as an association (taxable as a corporation) if a 10 percent or greater interest in the entity is "sold, exchanged, transferred or otherwise disposed of' in one or more steps "that occur (or are treated as occurring)" during a certain period.

Under Treas. Reg. [sections] 301.7701-3 (g)(1)(iii) (which was issued the same day as the proposed regulations), a corporation electing to be treated as a disregarded entity is deemed to distribute all of its assets or liabilities in a liquidation to the single owner. Treas. Reg. [sections] 301.7701-3(g) provides that the liquidation is deemed to occur the day before the effective date of the check-the-box election. Because every check-the-box election causes a deemed exchange or other disposition within the tainted period under section 331(a), each such election seemingly constitutes an extraordinary transaction under the proposed regulations.

The preamble to the proposed regulations states that a separate extraordinary transaction will be required to trigger the application of the regulations. 1999-50 I.R.B. at 670-71. The Institute recommends that this language be included in the body of the final regulations.

D. Effective Date of the Proposed Regulations. Prop. Reg. [sections] 301.7701-3(h)(5) provides that the regulations will be effective "on or after the date final regulations are published in the FEDERAL REGISTER." This is odd wording for regulations that are ostensibly prospective in application. It suggests that the regulations may be applied to transactions that have already taken place or taxable years for which returns have already been filed. If this is Treasury's intent, we suggest that it represents unsound tax policy. The check-the-box regulations were developed to reduce significantly the transaction costs related to setting up affiliated organizations; that is to say, they were intended to obviate a taxpayer's engaging in multiple steps to achieve a desired tax result that, within the check-the-box regime, can be effected in a single or at least fewer steps. To undo the rules retroactively is to deny taxpayers the ability to secure the tax consequences, that, with adequate notice, could likely have been achieved in any event.

Normally, prospective regulations are effective with respect to "transactions after" or "taxable years beginning after" a date certain. See, e.g., Treas. Reg. [sections] 301.7701-3(g) (effective for "elections that are filed on or after November 29, 1999"); Treas. Reg. [sections] 1.954-0(a)(1)(i) (effective for "taxable years of controlled foreign corporations beginning after November 6, 1995"); Treas. Reg. [sections] 1.482-1(j)(i) (effective "for taxable years beginning after October 6, 1994"); Treas. Reg. [sections] 1.267(f)-1(1)(1) (applicable to transactions "beginning on or after July 12, 1995"). TEI therefore recommends that the regulations be effective in respect of extraordinary transactions entered into after the date the final regulations are published.


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 Michael P. Boyle, chair of TEI's International Tax Committee, at (425) 936-8937, or Mary L. Fahey of the Institute's professional staff at (202) 638-5601.
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Publication:Tax Executive
Geographic Code:1USA
Date:May 1, 2000
Previous Article:Misrepresentation of a tax matter by a third party.
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