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Investing in Eastern Europe through hybrid entities can ease U.S. FTC problems.

More attention is being focused on structuring investments in Eastern Europe through "hybrid" entities because of high corporate income tax rates and U.S. restrictions limiting the ability of U.S. taxpayers to fully use foreign tax credits (FTCs). A "hybrid" entity is one formed in the foreign jurisdiction that is treated as a corporation for purposes of local income tax and corporate laws, but as a partnership for U.S. income tax purposes.

The top marginal corporate income tax rates in the countries that have attracted the greatest U.S. investment - Poland (40%), Hungary (40%) and the Czech Republic (45%) - are all higher than the current U.S. rate of 34%; only Russia, at 32%, is lower. However, if withholding taxes on dividends are taken into account, the effective foreign tax rates in these countries rise to 43% (Poland), 40% (Hungary), 59% (Czech Republic) and 42% (Russia).

In addition to the high foreign corporate income tax rates in Eastern Europe, FTC limitations can pose another problem. One FTC limitation especially relevant to U.S. corporations entering into joint ventures in Eastern Europe can apply when a foreign corporation is not a controlled foreign corporation (CFC). A CFC is a foreign corporation in which U.S. persons (each of whom owns at least 10% of the corporation's voting stock) in the aggregate own, directly or indirectly, more than 50% of the foreign corporation's stock, by vote or value (Sec. 957(a)). If the U.S. shareholder owns between 10% and 50% of the foreign corporation's voting stock, dividends received by the U.S. shareholder are subject to a separate FTC limitation (Sec. 904(d)(1)(E)). Any excess credits generated by these dividends can be used to offset only U.S. tax on dividends received in other years from this same corporation. In other words, unless the foreign corporation has (or will have) lower taxed earnings in other years from which dividends can (or will) be paid, these "excess" credits will be lost.

There are two situations in which a foreign "hybrid" entity may prove to be advantageous. The first occurs when a U.S. corporate shareholder owns 50% or less of the local entity's stock. If a U.S. taxpayer has "excess" FTC generated by an investment in a high tax country, it can sometimes be used to offset U.S. tax on income from low tax countries. However, as noted, U.S. rules do not allow this for dividends received by a U.S. corporation if it owns 50% or less (but at least 10%) of a foreign corporation and the foreign corporation is not a CFC. This special limitation does not apply if the foreign entity is considered a "partnership" for U.S. income tax purposes.

The second situation occurs when U.S. individuals are investors in the local entity. If the local entity is treated as a partnership for U.S. tax purposes, individual U.S. investors can achieve the same FTC benefits as a 10%-or-greater corporate shareholder enjoys from "deemed paid" tax credits. Since the partnership is a conduit for U.S. tax purposes, the individual shareholders are considered to bear the burden of the foreign tax directly.

However, a potential disadvantage of having a foreign entity treated as a partnership is that the U.S. investor will be currently taxed on its share of the "partnership" earnings, whether or not they are distributed. Thus, a U.S. investor who prefers to defer recognizing the income until the earnings are distributed would not want to use a hybrid entity. However, most Eastern European entities have losses in their initial years and, thus, the flowthrough of losses may be an advantage.

A foreign entity that is considered a corporation under local law will not necessarily be accorded the same treatment under U.S. law. Rather, the determination of whether a foreign entity is characterized as a corporation or partnership for U.S. tax purposes is governed by Rev. Ruls. 73-254 and 88-8. Both partnerships and corporations have the objective to carry on business at a profit. Most corporations (and all partnerships) also have more than one member or shareholder. However, an entity will be treated as a corporation if it possesses a majority of the following "corporate" characteristics: limited liability; continuity of life; centralized management; and free transferability of interests (Regs. Sec. 301.7701-2). An entity with no more than two of these characteristics will be treated as a partnership for U.S. tax purposes.

In Poland, Hungary, the Czech Republic and Russia, hybrid entities can be used to avoid the high foreign corporate tax rates and potentially avoid FTC limitation problems.


It is possible for a Polish corporation to be treated as a partnership for U.S. tax purposes since it can avoid all of the corporate characteristics except limited liability. The most popular forms of corporate vehicles for foreign investors are the joint stock company ("spolka akcyjna" (S.A.)) and the limited liability company ("spolka z ograniczona" (Sp. z o.o)). The S.A. is similar to a German AG and is distinguished by the fact that its capital is composed of transferable shares. The Sp. z o.o is similar to the German GmbH, and the rules governing its establishment are less formal than those for establishment of an S.A.

Both the S.A. and Sp. z o.o have the corporate characteristic of limited liability. While this characteristic can be avoided if the entity is a limited partnership (a "spolka komandytowa"), Polish law limits foreign investment to the S.A. and Sp. z o.o entities, or as a branch of a foreign corporation. Unlimited liability companies do not exist in Poland.

Under the Polish commercial code, a company's life may be limited by reasons provided in the company's charter or an appropriate resolution passed by the shareholders' meeting and recorded by a notary. The law does not provide any limitations on the nature of the reasons that may cause dissolution. Accordingly, the shareholders should be able to avoid continuity of life by specifying it will be terminated on a shareholder's death, bankruptcy or resignation.

Since the shareholders of an S.A. or an Sp. z o.o have the power to delegate ratification of business decisions, the articles of association can specify that all business decisions must be ratified by the "shareholders" at the annual shareholders' meeting, thus avoiding centralized management.

Finally, under Polish commercial law, a company's articles of association may specify that a shareholder's interest in the company may not be transferred without the consent of all other shareholders, thus avoiding free transferability of interests.


It is possible for a Hungarian corporation to be treated as a partnership for U.S. tax purposes because it can avoid the corporate characteristics of continuity of life and centralized management. Limited liability can be avoided by using an unlimited liability joint venture company or partnership.

There are two types of corporations in Hungary: the public limited company ("Reszvenytarsasag" Rt.)) and the limited company ("Korlatolt felelossegu tarsasag" (Kft.)). Foreign investors in Hungary most often choose to operate through the Kft., since it avoids the Rt.'s more formal rules designed to protect a wide mass of shareholders.

Both the Rt. and the Kft. offer limited liability protection for their shareholders. In order to avoid this characteristic, investors can choose to operate through a form of unlimited liability joint venture company ("Kozos vallalat" (Kv.)), or general ("Kozkereseti tarsasag" (Kkt.)) or limited ("Beteti tarsasag" (Bt.)) partnerships. Under the Hungarian company law, a company can be dissolved under a number of different circumstances, e.g., if the time period specified in its articles has expired, or another specified condition has been met. Accordingly, it is possible to avoid the characteristic of continuity of life if the shareholders specify in the articles that the company will dissolve on the death, insanity, retirement, resignation, expulsion or bankruptcy of an investor.

Normally, in a Kft., the executive authority resides in the managing director. However, centralized management can be avoided, since there is no prohibition under the Hungarian company law preventing the shareholders of a company from requiring all important business decisions to be ratified by all the shareholders.

The corporate characteristic of free transferability of interests cannot be avoided in a Kft. structure, since its members have a right of first refusal over the transfer of shares by any member. However, in both forms of partnership (Kkt. and Bt.), the members can provide in the articles that unanimous consent to a transfer of interest is necessary.

Czech Republic

A Czech company can be treated as a partnership for U.S. tax purposes because it can avoid, if desired, all the corporate characteristics except limited liability. Both joint stock ("Akciova spolecnost" (a.s.)) and limited liability ("Spolecnost s rucenim omezenym" (spol. s r.o.)) companies exist, and both are commonly used by foreign investors. An investor will however prefer the more flexible spol. s r.o. form unless there are good reasons to the contrary - for example, a large privatization project, or intended flotation (going public) on the fledgling Czech stock exchange. Investors in a spol. s r.o. do not hold shares, but have an entitlement to participation in the company.

The a.s. and spol. s r.o. entities both possess the corporate characteristic of limited liability. However, this can be avoided through the use of a general partnership ("Verejna obchodni spolecnost" (v.o.s.)) or a limited partnership ("Komanditni spolecnost" (k.s.)).

Investors in a Czech company can agree in the articles of association that the company will dissolve in the event of insanity, bankruptcy, retirement, resignation or expulsion of any investor; thus, continuity of life can be avoided. Similarly, investors can provide in the articles of association that all business decisions (other than purely administrative ones) must be ratified by the investors, thus avoiding centralized management.

The articles of association of a spol. s r.o. may provide that a member cannot transfer its participation in the company without the unanimous consent of all other members. (Similar constraints can be made in the articles of an a.s., although not as easily.) Thus, free transferability of interests can be avoided.


Finally, a Russian entity can probably be treated as a partnership for U.S. tax purposes provided it is also structured as a partnership under local law and avoids the corporate characteristic of continuity of life. Joint stock companies come in two forms in Russia: "open type" (OJSC) and "closed type" (CJSC). Both forms have the corporate characteristic of limited liability. In addition, there are full and limited liability partnership entities. Most foreign investors choose to do business through the CJSC or the limited liability partnership. There is little experience as yet with regard to registration of full partnerships so they are not a practical choice at present.

While the issue is not free from doubt, it may be possible to provide in the foundation documents of a limited liability partnership that the company will dissolve in the event a participant becomes insane, bankrupt, retires, resigns or is expelled from the company, and thus avoid continuity of life.

The management of Russian entities is similar to that of U.S. entities. A board of directors is appointed by the shareholders. The board appoints a general director who oversees the day-to-day company business. The shareholders retain only limited responsibility for business decisions. Thus, it is not possible to avoid the corporate characteristic of centralized management.

Interests in commercial entities (both companies and partnerships) generally are not freely transferable. In limited circumstances, the shares of an OJSC may be transferred without prior consent of other shareholders.

Therefore, it seems possible to draft the foundation documents of a limited liability partnership in a manner that avoids continuity of life and free transferability of interests so that the company is treated as a partnership for U.S. tax purposes.


Most of Eastern Europe's favorable tax incentives targeted to Western investors have been repealed. This repeal coupled with the high corporate tax rates makes the use of hybrid entities more desirable. U.S. investors in Eastern Europe may be able to effectively manage their U.S. FTC position if they carefully consider the use of "hybrid" entities for making their investments.
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Article Details
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Title Annotation:foreign tax credit
Author:Eigenbrode, Richard
Publication:The Tax Adviser
Date:Jul 1, 1993
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