Checking the Box, Partnership Allocations, and Foreign Law

October 16, 2017

Many of our clients, most of which are closely-held U.S. businesses, are looking to expand their operations overseas. Some are venturing into foreign markets on their own, while others are joint-venturing with established foreign businesses.

In structuring a joint venture, the parties will often form a foreign business entity that affords a significant degree of limited liability protection, such as a corporation.

As a matter of U.S. Federal tax law, however, it may be advisable that the form of foreign entity not be treated as a corporation per se. Rather, the better choice may be that the foreign entity qualify as a so-called “eligible entity” under U.S. tax law – one that provides limited liability protection to its members but that may elect to be treated as a partnership.

If the foreign eligible entity is treated as a partnership for U.S. tax purposes, a share of the losses that may be generated by the entity in the early stages of its operation may flow through to the U.S. business to be used in determining its taxable income.

The IRS recently considered an interesting version of this scenario.

Joint Venture

In Year 1, US Parent corporation and Foreign Parent corporation formed JV, as a foreign limited liability company, to carry out a joint venture. As a matter of Foreign Law, JV had two equity owners: foreign corporations FC-1 and FC-2, each of which contributed funds to JV. US Parent and Foreign Parent owned the equity of FC-2; Foreign Parent was the sole owner of FC-1.

US Parent also provided funds to JV through its U.S. subsidiary, US Partner, and Foreign Parent did so directly. The amounts provided were treated as loans under Foreign Law. Thus, under Foreign Law, JV was treated as having two owners: FC-1 and FC-2.

Check the Box

US Parent elected to treat JV as a partnership for U.S. Federal tax purposes. US Parent also treated the amounts provided to JV by US Partner and Foreign Parent as equity, rather than debt. As a result, for US tax purposes, JV was treated as having four partners: FC-1, FC-2, US Partner, and Foreign Parent. Thus, the partnership allocation rules became applicable for purposes of determining US Partner’s share of JV’s tax items.

The joint venture agreement for JV did not set forth any of the “economic effect test” provisions regarding capital account maintenance, liquidation in accordance with positive capital accounts, or deficit restoration obligations; nor did it specify the allocation of JV/partnership tax items among the partners.

Additional Funding

Foreign Law required that, in order for an entity to maintain its legal status as a limited liability company, it should have net assets greater than or equal to its charter capital.

If an entity’s net assets were less than its charter capital, then the entity must either (1) decrease its charter capital, or (2) obtain additional contributions from its owners. If the entity’s owners do not take steps to improve its negative net asset position, the Foreign governmental authority may seek the liquidation of the entity. Furthermore, where an entity improves its net asset position by reducing its charter capital, in lieu of obtaining contributions from its owners, Foreign Law allows any creditor to seek the liquidation of the entity.

The JV Agreement required the owners of JV to lend additional funds pro-rata to their respective ownership interests in JV whenever JV lacked sufficient assets to meet these funding requirements.

Guaranteed Payments

According to the JV Agreement, US Partner and Foreign Parent would receive fixed payments related to their contribution amounts. The fixed payments were computed without regard to the income and cash flow of JV.

US Parent characterized these payments by JV to US Partner as guaranteed payments (for U.S. tax purposes) for the use of capital. From Year 2 to Year 5, JV deducted its payments to US Partner as guaranteed payments. JV had cumulative operating losses from Year 2 to Year 6. The guaranteed payments generated much of these losses. The loss deductions were allocated by JV solely to FC-2 and FC-1.

End of the Joint Venture

After several years of disappointing results, Foreign Parent and US Parent reached an agreement for US Parent to sell its indirect interest in JV to Foreign Parent. Because no JV loss deductions had been allocated to US Partner, US Partner’s basis in JV at the time of the sale was not insignificant and, as a result, US Parent reported a loss of on its U.S. return attributable to the sale of US Partner’s interest in JV.

The IRS’s Analysis

After examining the U.S. Parent’s tax return, the IRS field office asked the National Office to consider the proper allocation of JV’s losses. The IRS examiner believed that part of the loss allocated to FC-2 should have been allocated to US Partner, while US Parent argued that FC-2 bore the economic risk of JV’s operating losses.

Allocation Rules

Under the Code, a partner’s distributive share of income, gain, loss deduction, or credit (or item thereof) is determined in accordance with the partner’s interest in the partnership (taking into account all facts and circumstances), if:

  • the partnership agreement does not provide as to the partner’s distributive share of the partnership’s income, gain, loss, deduction, or credit (or item thereof), or
  • the allocation of such items to a partner under the agreement does not have substantial economic effect.

The IRS applies a two-part analysis for determining substantial economic effect:

  • the allocation must have economic effect; and
  • the economic effect of the allocation must be substantial.

An allocation of partnership income, gain, loss, or deduction to a partner will have economic effect if the partnership agreement provides that:

  • the partnership will maintain a capital account for each partner;
  • the partnership will liquidate according to positive capital account balances; and
  • the partners are obligated to restore any deficit balances in their capital accounts following a liquidating distribution.

If an allocation lacks substantial economic effect, the IRS requires that the item be allocated in accordance with the partners’ interest in the partnership.

“Partner’s Interest”

A partner’s “interest in the partnership” signifies the manner in which the partners have agreed to share with that partner the economic benefits or burdens corresponding to the income, gain, loss, deduction, or credit of the partnership. The determination of a partner’s interest in a partnership is made by taking into account all facts and circumstances relating to the economic arrangement of the partners.

The IRS explained that a partner receives income, not a distributive share, from a guaranteed payment for the use of capital, and the partnership receives a corresponding business deduction. The income from the guaranteed payment does not affect the recipient’s basis in its partnership interest or its capital account. The partnership’s deduction for the guaranteed payment reduces the partnership’s income (or increases the partnership’s loss) to be allocated among its partners.

Because they were determined without regard to the income of the JV-partnership, the fixed payments made by JV to US Partner and Foreign Parent from Year 2 to Year 5 were guaranteed payments for the use of capital. The guaranteed payments generated ordinary income for US Partner and Foreign Parent and deductions for JV.

During this period, JV incurred operating losses, primarily as a result of the guaranteed payment deductions. These losses were allocated entirely to FC-2 and FC-1. US Partner and Foreign Parent received no allocation of loss.

The IRS found that the allocation of JV’s operating loss did not have economic effect because JV did not maintain capital accounts, it did not provide for the liquidation of its partners’ interests in accordance with positive capital account balances, nor did it provide a deficit restoration obligation.

Thus, the IRS continued, JV’s operating loss had to be reallocated in accordance with the partners’ interests in the partnership, reflecting the manner in which the partners agreed to share the economic burden corresponding to that loss.

US Parent argued that Foreign Law effectively subjected FC-2 to a deficit restoration obligation because, if JV’s capitalization fell below a certain threshold, the equity holders of JV (FC-1 and FC-2 under Foreign Law; not US Partner and Foreign Parent) would need to contribute additional capital to JV to avoid its liquidation.

The IRS rejected this argument, finding that these additional capital contributions were not required by Foreign Law, as JV’s partners could allow JV to liquidate rather than make these additional contributions. While FC-2 and FC-1 did contribute additional amounts to JV after Year 2, these amounts were minimal compared with the substantial additional amounts contributed to JV by US Partner and Foreign Parent.

As creditors under Foreign Law, US Partner and Foreign Parent had priority over FC-2 and FC-1 if JV was liquidated. However, FC-2 and FC-1 had no obligation to restore any shortfall in payments to US Partner and Foreign Parent upon liquidation. Consequently, JV would not have the assets to repay US Partner and Foreign Parent their positive capital account balances upon liquidation, thus placing the economic burden for the operating loss allocations to FC-2 and FC-1 on US Partner and Foreign Parent. Any capital contributions by FC-2 and FC-1 would be necessary only to keep JV a going concern and avoid liquidation in the event JV became undercapitalized. Whether to keep JV a going concern would be up to US Parent and Foreign Parent, and was not mandated by Foreign Law.

Based on the foregoing, the IRS concluded that the allocation of JV’s loss to FC-2 and FC-1 should be limited to the amount of their positive capital account balances. They bore the burden of the economic loss of their capital contributions on liquidation up to this amount.

In addition, the IRS concluded that US Partner and Foreign Parent bore the economic burden of JV’s losses in excess of those positive capital accounts.

Don’t Forget

U.S. persons are subject to U.S. income tax on their worldwide income. Thus, before selecting the form of foreign entity through which to begin its foreign operations, a U.S. person should consider the options available.

The form of foreign entity ultimately chosen must be optimal from a business perspective, and it should afford the U.S. person limited liability protection.

However, as always, the tax consequences of a business structure may have a significant effect on the net economic benefit of a transaction, including the foreign operations of a U.S. business. Therefore, the U.S. person should consider how the applicable foreign law will affect the foreign entity’s tax status from a U.S. perspective.

The U.S. person should also examine how each option would be treated for U.S. tax purposes – as a corporation, partnership, or disregarded entity, and whether a check-the-box election would be advisable – and how the tax items attributable to the foreign business may impact the U.S. person’s overall tax liability.

The choice of foreign business entity should be approached with an eye toward maximizing the U.S. person’s overall foreign and U.S. tax benefits, including the use of foreign losses and foreign tax credits, and the deferral of foreign income.

The process is far from simple, but it is absolutely necessary.