Key insights
- Understanding the basic framework of check-the-box regulations can help buyers and sellers identify potential U.S. income tax and reporting risks.
- A thorough understanding of a U.S. target’s global tax structure can allow buyers to plan for postacquisition restructuring.
- Accurate reporting of a U.S. target’s global tax structure can allow both buyers and sellers to negotiate tax-efficient deal structuring.
Have questions regarding cross-border deal structuring or international tax due diligence?
Understanding the basic framework of tax classification regulations can help buyers and sellers identify potential U.S. income tax and reporting risks and plan for post-acquisition restructuring. Read some tips on what U.S. corporate owners of foreign subsidiaries can do to be better prepared.
Domestic vs. foreign entity tax classifications
U.S. limited liability companies are a flexible investment vehicle, eligible to elect to be taxed as corporate or pass-through entities for U.S. tax purposes. By default, it will be treated as a pass-through entity unless it specifically elects to be treated as a corporation.
The U.S. similarly allows certain foreign entities to elect their tax classification status for U.S. tax purposes. Unlike a domestic LLC, a foreign eligible entity’s default U.S. tax classification will depend on whether its owners have limited liability: if all owners have limited liability, the default U.S. tax classification is corporation; if at least one owner has unlimited liability, the default tax classification would be a pass-through.
Why does the U.S. tax classification of a foreign entity matter?
Penalties
A U.S. entity that owns at least 10% of a foreign corporation may be considered the owner of a controlled foreign corporation (CFC), depending on the residency of the remaining shareholders. A U.S. company that owns at least 10% of a CFC is subject to additional U.S. tax reporting requirements. Missed or late filing of the proper tax forms can cause thousands of dollars in penalties, and can result in a significantly reduced purchase price on acquisition.
Income
In addition to the reporting requirements, the U.S. income tax implications of a foreign subsidiary’s U.S. tax classification vary widely. Incorrect reporting related to U.S. tax classification can lead to significant over- or under-payment on income or losses flowing from foreign subsidiaries.
Foreign corporation that is not a CFC
A U.S. person that owns an interest in a corporation that is not a CFC will not be required to include any of that corporation’s income in its U.S. gross income unless and until the foreign corporation enters into a transaction with the U.S. person. A U.S. corporate owner may qualify for a foreign dividends received deduction; if not, it may credit any associated foreign withholding taxes against its U.S. tax liability on dividend income.
Foreign corporation that is a CFC
A U.S. person owning at least a 10% interest in a CFC is subject to anti-deferral provisions such as global intangible low-taxed income (GILTI) and subpart F, each of which require the U.S. person to include at least a portion of the CFC’s income in U.S. gross income using a deemed dividend concept. If applicable, the U.S. owner must include these amounts in U.S. gross income regardless of whether an actual dividend has been paid by the CFC.
Foreign partnership
A U.S. partner in a foreign partnership is required to include its pro rata share of items of income, gain, loss, and expense on its U.S. tax return, just as the partner would with an investment in a U.S. partnership. In cases where a foreign entity is treated as a corporation in its country of organization, and as a partnership for U.S. tax purposes, the U.S. owners may need to enter into separate legal agreements to comply with U.S. partnership rules surrounding the allocation of these partnership items.
Disregarded foreign entities
When a foreign eligible entity that is 100% owned by a single U.S. company elects to be treated as a pass-through entity for U.S. tax purposes, it will be considered disregarded as a separate entity for U.S. tax purposes. The U.S. owner is treated as directly owning all the assets and liabilities held by that foreign disregarded entity and is treated as directly receiving all items of income, gain, loss, and expense.
Foreign tax credits
The IRS allows U.S. taxpayers to utilize creditable taxes paid in a foreign country to reduce their U.S. tax liability on foreign-source income to the extent it is included in U.S. income. The use of foreign tax credits is limited to the U.S. taxpayer’s foreign tax credit limitation.
U.S. taxpayers must calculate a separate foreign tax credit limitation for each applicable bucket: passive, general, foreign branch, and GILTI. A U.S. taxpayer with a foreign subsidiary will determine the creditability and categorization of any foreign taxes paid by that subsidiary based largely upon the foreign entity’s U.S. tax classification.
How we can help
In the context of cross-border mergers and acquisitions, having a foundational knowledge of U.S. classification rules for foreign entities can help both sides of the transaction. Sellers can provide prospective buyers with accurate legal entity organizational charts, and buyers can gain a better understanding of the global footprint of the target and be better prepared to plan for post-acquisition restructuring.
In addition to our experienced investment bankers, our broader CLA team often comprises senior due diligence and transaction services practitioners, accounting and international tax professionals, and wealth advisors. Working with your legal counsel, CLA can seamlessly guide you through the entire transaction process.