Rev. rul. 93-4 (entity classification).
This letter addresses several issues raised by Rev. Rul. 93-4, 1993-3 I.R.B. 5 (Jan. 19, 1993), relating to the classification of foreign organizations for tax purposes. The ruling, which was issued on December 23, 1992, modifies Rev. Rul. 77-214, 19771 C.B. 408.
TEI commends the Internal Revenue Service for issuing Rev. Rul 934. The ruling significantly clarifies the classification of an entity under German law for federal income tax purposes. We believe that the new ruling represents a positive first step in righting the imbalance between foreign and domestic entities that was created by Rev. Rul. 77-214.
We also commend the IRS for exercising its authority under section 7805(b) of the Code to apply rules and regulations prospectively. Rev. Rul. 93-4 provides that organizations existing prior to February 18, 1993, that reasonably relied upon Rev. Rul. 77-214 may maintain their current classification by reporting consistently with that classification on the first federal income tax return of the organization or member filed after that date. The new ruling is thus given prospective effect for entities that wish to retain their corporate status. Modifying Rev. Rul. 77-214 on a retroactive basis could have created more uncertainty in the international area by casting doubt on the corporate status of German entities. The prospective application of Rev. Rul. 93-4 for those taxpayers seeking to retain corporate status is a sensible approach.
In spite of the strides toward simplification and clarity made in Rev. Rul. 93-4, more needs to be done. Taxpayers need an entity classification system that yields clear and predictable results.(1) Since Rev. Rul. 77-214 was not revoked in its entirety, some remnants of its holding on the free transferability of interests and the application of the economic interests test remain. TEI believes it is time for the IRS to totally abandon the rationale set forth in the 1977 ruling since there is no potential for abuse that requires adherence to the single economic interest theory. Nor is any policy served by "looking behind" the legal restrictions set forth in an entity's memorandum of association.(2)
Moreover, taxpayers should be accorded substantial flexibility to structure a foreign entity as either a corporation or a partnership for U.S. tax purposes. TEI believes the rules relating to the classification of foreign entities should be readily adaptable to foreign legal requirements. Taxpayers filing consolidated returns that wish to achieve flow-through treatment for an overseas entity may currently do so by establishing a domestic subsidiary with a branch operation abroad. Such an approach, however, restricts taxpayers' flexibility under local law. Foreign procedural or administrative requirements (such as actions required to dissolve an entity) should not preclude taxpayers from achieving partnership classification. Finally, we suggest that the IRS issue general guidance for classification of all foreign entities.
The IRS Should Eliminate the Single Economic Interest Test and Withdraw Rev. Rul. 77-214
Section 7701(a)(3) of the Code provides that the term "corporation" includes "associations, joint-stock companies, and insurance companies." Treas. Reg. [paragraph] 301.7701-2(a) defines an association as having the following six corporate characteristics: (1) associates; (2) an objective to carry on business and divide the gains therefrom; (3) continuity of life; (4) centralization of management; (5) liability for corporate debts limited to corporate property; and (6) free transferability of interests.(3) For purposes of determining whether an entity is a corporation or a partnership, the first two factors are ignored. An association will be treated as a corporation if it possesses three out of four of the remaining characteristics.
In Rev. Rul. 77-214, the IRS considered whether a German Gesellschaft mit beschrankter Haltung (GmbH) would automatically be classified as an association taxable as a corporation for federal income tax purposes. In that case, the GmbH was formed by two wholly owned U.S domestic subsidiaries of a U.S. corporation. The GmbH's memorandum of association provided that the GmbH would be dissolved by the death, insanity, or bankruptcy of any of the quotaholders (shareholders). It also provided that the "quotas" of .the GmbH were not freely transferable, requiring the prior written approval of all quotaholders to sell, pledge, or dispose of the quotas. The IRS first stated that a GmbH may be classified as a corporation or a partnership, depending upon the construction of the memorandum of association. The issues to be resolved were whether the GmbH possessed free transferability of interests and whether it satisfied the continuity-of-life requirement.(4) If the entity possessed either characteristic, it would be taxable as a corporation under Treas. Reg. [paragraph] 301.77012(a).
With respect to the free transferability of interests, the IRS stated that because the GmbH was wholly owned by two domestic subsidiaries, the controlling parent could make all of the decisions, "despite any provision in the memorandum of association." Because of this single economic interest, the IRS ruled that the GmbH possessed the corporate characteristic of free transferability.
With respect to the continuity of life requirement, the IRS ruled that the dissolution upon the bankruptcy of a member had significance "only if there exist separate interests that could compel dissolution of the organization .... "Because the quotaholders were wholly owned by a single parent, the IRS ruled there were no separate interests to compel dissolution. The dissolution statement in the memorandum of association was thus ignored and the GmbH was found to have the corporate characteristic of continuity of life. The GmbH therefore possessed all six characteristics of a corporation.
Rev. Rul. 77-214's "single economic interest" theory and "separate interests'' test caused confusion, consternation, and concern in the tax community. The ruling seemingly conflicted with an earlier ruling relating to the characterization of a domestic entity where four wholly owned domestic subsidiaries of a U.S. parent organized a joint venture under a statute similar to the Uniform Partnership Act; the joint venture was held to be a partnership for federal tax purposes. See Rev. Rul. 75-19, 1975-1 C.B. 382. Unlike the ruling dealing with a foreign entity, the IRS did not look behind the parties' legal relationship in reaching its conclusion. See also MCA, Inc. v. United States, 685 F. 2d 1099, 1104 n. 13 (9th Cir. 1982) (noting the conflict between Rev. Rul. 77214 and Rev. Rul. 75-19). A later ruling in the domestic area also conflicted with the single economic interest theory. Rev. Rul. 83-156, 1983-2 C.B. 66 (joint venture formed by two related domestic corporations is taxable as a partnership). The uncertainty was compounded by the IRS's own application of the ruling. See, e.g., Private Letter Rulings 9103033 (October 23, 1990) and 9122074 (March 6, 1991) (holding that a French societe en nom collectif (SNC) qualified as a partnership, even though held indirectly by a single corporate parent).
In Rev. Rul. 93-4, the IRS reconsidered Rev. Rul. 77-214. On facts identical to those in the 1977 ruling, the IRS stated that the presence or absence of separate interests was not relevant in determining whether an entity possesses continuity of life. Because the memorandum of association required dissolution upon the bankruptcy of either quotaholder, the IRS ruled that the GmbH lacked continuity of life. Rev. Rul. 93-4 thus rejects the earlier ruling's separate interests test. In the course of the ruling, the IRS cited Rev. Rul. 75-19.
The IRS went on to state, however, that where two commonly controlled interests own 100 percent of the GmbH, consent to transfer interests is not meaningful. It therefore "reaffirmed" Rev. Rul. 77-214's holding that a wholly owned GmbH possesses the corporate characteristic of free transferability of interests. At the same time, however, the IRS stated that if the memorandum of association had either (i) prohibited the transfer of an interest or (ii) provided for the dissolution of the GmbH upon transfer of an interest, the GmbH would have lacked free transferability. By outlining circumstances in which free transferability will not be found, the 1993 ruling essentially attempts to provide a "road map" for taxpayers seeking partnership status.
Although Rev. Rul. 93-4 clarifies the scope of the continuity-of-life test, its embrace of Rev. Rul. 77-214's holding on free transferability is troubling. In Rev. Rul. 93-4, the IRS found that the provision requiring the written approval of all quotaholders prior to transfer "not meaningful" because of the common control of the GmbH members. The rationale for this holding is that "[t]o lack free transferability, the possibility of an impediment must exist." The 1993 ruling states, however, that a provision prohibiting transfers or providing for dissolution upon transfer will cause an entity to lack free transferability, even if the quotaholders share a common ownership. 1993-3 I.R.B. at 6.
TEI sees no reason to distinguish between foreign and domestic entities for entity classification purposes. In Revenue Ruling 75-19, the IRS ruled that four related entities could form a partnership under a statute similar to the Uniform Partnership Act. The form the entities chose to operate in was respected and the single economic interest test was not even discussed. Nor do the section 7701(a)(3) regulations differentiate between foreign and domestic entities.
Moreover, with respect to certain foreign entities, the single economic interest theory creates arbitrary distinctions between entities that are controlled by related and unrelated parties. For example, it is unclear whether a Dutch Beslogen Venootschap (B.V.) that is controlled by related parties could be structured to qualify as a partnership under Rev. Rul. 93-4, although it is clear that a B.V. controlled by unrelated parties could so qualify.(5) We suggest that the rules relating to free transferability should be sufficiently flexible to accommodate the vagaries of foreign law. If the separate interests doctrine were eliminated, a requirement for shareholder consent would satisfy both the foreign and U.S. requirements and would be consistent with the existing regulations as applied to domestic entities in Rev. Rul. 75-19.
Rev. Rul. 93-4's reference to Rev. Rul. 75-19 seemingly signals a desire to bring conformity to the ruling policy for domestic and foreign entities. We suggest that the IRS go one step farther and expressly jettison Rev. Rul. 77-214's holding on the free transferability of interests. In MCA Inc. v. United States, 685 F. 2d at 1105, the court noted that the regulations "prescribe a mechanical and formalistic test, . . . permitting taxpayers to select a form of business organization with certainty about the attendant tax consequences." The single economic interest theory should be completely abandoned.
Interaction of Rev. Rul 93-4 With Foreign Procedural Rules
Rev. Rul. 93-4 provides that the presence or absence of separate interests is irrelevant to whether an entity lacks continuity of life. The IRS concluded because the GmbH's memorandum of association requires dissolution upon the bankruptcy of either quotaholder, "without further action," the GmbH lacked continuity of life. 1993-3 I.R.B. at 6. That foreign law requires a shareholder vote upon insolvency of a shareholder, however, should not prevent an entity from being treated as a partnership where the substance of the shareholders' relationship (whether or not they are related) is such that dissolution inevitably results under such circumstances.
TEI believes that a taxpayer should not be precluded from structuring a foreign entity as a partnership for U.S. tax purposes because of ministerial requirements under foreign law. The IRS has long permitted taxpayers to satisfy the tax-free reorganization provisions of section 368 by disregarding transitory steps required to satisfy foreign legal requirements. See, e.g., Rev. Rul. 83-142, 1983-2 C.B. 68. We submit a similar approach should be taken in the area of foreign entity classification.
Flexibility is particularly important with respect to the laws of the United Kingdom where dissolution cannot be automatic. See Companies Act of 1985, Part XX, Chap. III, [paragraph] 572(1)(a), Halisbury's Statutes of England and Wales (Vol. 8) (4th ed. 1983 and Supp.). The company seeking to dissolve must first go into liquidation-an action that requires a meeting and vote of the remaining shareholders. Such a ministerial act should not be considered an impediment to obtaining partnership status.(6) We recommend the requirement that dissolution occur "without further action" be deemed satisfied where the organizational documents require shareholders to vote in favor of dissolution (perhaps also requiring that shareholders submit irrevocable proxies as a condition to acquiring their interest).
The Issuance of Generic Guidance
Treas. Reg. [paragraph] 301.7701-2(e)(1) provides that an organization has free transferability of interests if all of its members, or those members owning "substantially all" of the interests in the organization, have the power to substitute for themselves persons who are not members of the group. What constitutes "substantially all" of the interests is generally to be determined by the facts and circumstances of the case. See Rev. Rul. 57-518, 1957-2 C.B. 253, 254. The regulations, however, were intended to resolve most questions in favor of partnership status. See Zuckman v. United States, 207 Ct. Cl. 712,721 n.5 (1975).
Rev. Proc. 89-12, 1989-1 C.B. 798, sets forth conditions under which the IRS will consider a ruling request on the classification of an entity as a partnership for federal income tax purposes, and Rev. Proc. 92-33, 19921 C.B. 782, supplements that ruling by providing that an entity lacks free transferability if the partnership agreement restricts the transferability of partnership interests representing more than 20 percent of all interests in partnership capital, income, gain, loss, deduction, and credit. Notwithstanding the "substantially all" test, Rev. Rul. 93-4 seems to absolutely prohibit the transfer of interests. TEI believes that the "substantially all" test should be the controlling factor in both affiliated and unrelated ownership cases.
Whether or not taxpayers are afforded additional flexibility to structure foreign entities as partnerships, the Dutch and U.K examples demonstrate the need for additional guidance with respect to the classification of foreign entities. TEI recommends that the IRS issue a revenue procedure providing generic guidance relating to the classification of all foreign entities and specifying the circumstances under which the IRS will issue a ruling.
We further recommend that such a procedure include objective standards similar to the broad guidance set forth in Rev. Proc. 89-12 and Rev. Proc. 92-33. In particular, the procedure should address whether the single economic interest theory is retained with respect to any entity characteristics, and, if so, how the test for such characteristic applies differently where an entity is controlled by related parties. In addition, the procedure could expressly incorporate the "substantially all" test of Rev. Proc. 92-33 in classifying a foreign entity as either a partnership or an association. The issuance of generic guidance in this area is a sensible approach to providing certainty and stability for taxpayers and the government. In the absence of such guidance, the IRS should consider issuing a revenue procedure addressing specific foreign entities in specific countries. At a minimum, the IRS should publish a list of countries in which commonly used corporate forms may (and may not) be structured as partnerships for U.S. tax purposes. TEI would be pleased to assist the IRS in this area.
Tax Executives Institute appreciates this opportunity to present our views on Rev. Rul. 93-4, relating to the classification of a foreign organization for tax purposes. If you have any questions, please do not hesitate to call Lisa Norton, chair of TEI's International Tax Committee, at (201) 573-3200 or Mary L. Fahey of the Institute's professional staff at (202) 638-5601.
(1) See, MCA Inc. v. United States, 685 F. 2d 1099, 1105 (9th Cir. 1982).
(2) Prior to 1986, a "dual resident company"--a company taxable on its worldwide income in both the United States and a foreign jurisdiction with a regime similar to the U.S. consolidated return provisions--could use any losses it generated both to offset the income of its affiliates resident in the United States (but not abroad) and to offset the income of its affiliates resident only in the other country. This practice was known as "double dipping," Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 99th Cong., 2d Sess. 1063-64 (1987). The Tax Reform added section 1503(d), applicable to branches and corporate subsidiaries, which provides that if a U.S. corporation is subject to a foreign country's tax on worldwide income or on a residence basis (as opposed to a source basis), any net operating loss it incurs cannot reduce the taxable income of any other member of a U.S. affiliated group for that or any other taxable year.
(3) These factors are commonly called the "Morrissey" factors, based on a case with that name. Morrissey v. Commissioner, 296 U.S. 344, 359 (1935).
(4) The IRS found that under German law, the GmbH possesses the characteristics of limited liability and centralization of management.
(5) Under Dutch law, it is uncertain whether an entity whose memorandum of association expressly provides for the dissolution of the legal entity upon a transfer of shares by a shareholder would qualify as a B.V. Section 2:195, paragraph 7, of the Dutch Civil Code provides that "[a] restriction of transfer may not be made to such extent as to render transfer impossible or exceedingly onerous." If a transfer causes the dissolution of the B.V., the transfer of shares would arguably be considered "exceedingly onerous" under Dutch law.
(6) Two commentators have suggested that this problem could be avoided by having the U.K. company's governing documents provide if any shareholder fails to vote, or votes against the resolution, such a vote will be deemed cast in favor of liquidation. The authors believe that such a predetermined contractual arrangement should satisfy Rev. Rul. 93-4's requirements. See J. Hayden & H. Mogenson, Revenue Ruling 93-4 IRS Rethinks Revenue Ruling 77-214 and Provides a Practical Approach, 22 Tax Management Internat'l J. (No. 4) 195, 19899 (April 9, 1993).
Update on TEI Scholarship Program
Ten TEI chapters have established scholarship programs to encourage students to consider careers in corporate taxes: Dallas, Florida, Houston, Montreal, New Jersey, New York, Philadelphia, Seattle, Toronto, and Westchester-Fairfield. The scholarship programs are governed by a comprehensive set of guidelines that were adopted by the Institute's Board of Directors in 1990.
The scholarships granted under the chapter programs generally range from $500 to $1,500. Although the programs are generally funded exclusively with chapter funds, there have been some exceptions. In 1990, the New York Chapter's grant of a $1,000 to Baruch College of the City University of New York was matched by a contribution from two companies, Loews Corporation and Quantum Chemicals. In addition, the Montreal Chapter's scholarship program was initially funded with a $5,000 grant from the Quebec government, and the provincial government has renewed its participation in the program for the coming year.
The chapters generally permit the college or university to choose the scholarship recipient according to its own criteria. Last year, however, the New Jersey Chapter awarded five scholarships on the basis of essays submitted by students from various local universities. (The essays were judged by representatives of the colleges.)
For further information about the establishment of a scholarship program, contact Mary L. Fahey, TEI Assistant Tax Counsel, at TEI Headquarters.
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|Title Annotation:||foreign organizations|
|Date:||Sep 1, 1993|
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