Contents:
1.0 Introduction
2.0 Tax Classification: Civil & General Law
3.0 Corporate Investment Vehicles, Foreign Hybrids & Limited Partnerships
4.0 Check-The-Box Regime
5.0 Corporate Social Responsibility Vs the Burden of Tax
6.0 Tax Competition > Corporate Tax Rate
7.0 Retained Profits & Dividend Taxation for Entities
8.0 C & S Corporations
9.0 Treaty Shopping
10.0 OECD BEPS Action 2 Direction
11.0 Conclusion
12.0 Reference List
1.0 Introduction
Freedom of entity choice allowed through tax laws offers a more favourable tax treatment of entities for tax planning. The resulting increased business activity is from entities who are solely established to attempt to minimise tax through income shifting between personal and corporate tax bases. (Alstadsæter & Wangen, 2008, p.2) The tax treatment of entities from a civil or general law classification standpoint, provides an explanation of the definitions for: S corporation, C corporation, limited liability company, limited partnership, trust, company or general partnership. A key consideration is also the non-tax factors that also impact upon the decisions of management, such as opportunity costs, trade agreements and corporate social responsibility. The countries under analysis include Australia, the United Kingdom, Germany and the United States; the pros and cons of each system will be covered and what we can learn from each country. The tax treatment of entities in an international perspective offers more favorable opportunities for tax planning when considering regimes such as Check-The-Box, and more complexity when considering OECD action under BEPs regimes.
2.0 Tax Classification: General & Civil Law
The study of corporate income tax can be unusual in a common law system, due to it being a statute based subject. While judges have provided interpretations to the words in the statute, this however does not provide in explicit detail a meaning for all forms of corporate transactions. Despite, remaining uneducated on the law will not stop taxation, rather we must try to compensate for our knowledge gaps by weighing up each law, precedent and general definition in comparison to one another. This is to provide a clear understanding under each specific tax context. “One important difference between the U.S. tax approach to entity classification and the approach used in other countries is that other countries generally undertake the task only to classify foreign entities” (Blanchard, 2016, p.14) Germany, the UK, the US and Australia all rely on what form an entity is in the general law in its home country, and what are the rights and relations these foreign entities have overseas.
The general method is to look at which entities have similar characteristics to corporations and therefore are also taxed as if they are corporations. These can include: Australian corporate limited partnerships (Austlii, 2016, Div 5a), UK unit trusts (Financial Services Act; CTA 2010 s. 617), and US publicly traded partnerships (IRC, 1954, §§ 7704). “An obvious shortcoming of this approach is that it is hardly useful when the entity encountered bears no resemblance at all to any local entity, such as a common law trust from the point of view of a civil law country like Germany.” (Blanchard, 2016, p.14) Definitions will change depending on the country, however the general definition of corporation will be an artificial entity recognised as an independent person by the law with capital or ownership interests divided into shares that are freely transferable.
Both laws accept that a corporation can be made of a body of persons that make and calculate its profits as if it were one individual. Separate legal entities are separated by their ‘corporate veil’ between the shareholders and the company. (Lavermicocca & Buchan, 2015, p.7) An entity under civil law is given a separate legal personality, though under tax law may not always coincide with this status. “[As such the U.S.] has abandoned any conceit that limited liability matters to entity classification for tax purposes, given the reality that almost any type of U.S. entity can today afford almost complete protection from liability.” (Blanchard, 2016, p.8)
3.0 Corporate Investment Vehicles, Foreign Hybrids & Limited Partnerships
The status for separate legal personality changes between, jurisdictions, law and the type of entities. In many civil law countries partnership entities simply do not have a separate legal personality, likewise in common law jurisdictions they don’t at general law. Europe and the UK both accept separate legal personalities for partnerships, both at the general law and corporate law. In the US they have entities such as Limited Liability Company (LLC), where they did not give a corporation legal personality. Internationally, the dominating influence of the US has again set the standard of using tax transparent limited partnerships and limited liability companies rather than trusts for Collective Investment Vehicles designed to attract such investors.
Before this trend, Australia decided in the early 1990s to tax limited partnerships as companies in order to limit their use for tax shelters. Since then, Australia has adopted limited transparency for specific types of limited partnerships and has been looking at developing a new form of limited partnership. Australia has also adopted further changes to make its law under ITAA 1997 Division 830 for companies listed as controlled foreign companies under ITAA 1936 Part X, to be more consistent internationally with other countries’ regimes for CIVs. (Austlii, 2016, Div 830)
Likewise, the UK also introduced new rules for LLC, in a decision by the UK Court of Appeal in HMRC v Anson. That LLC should be treated as opaque for UK foreign tax credit purposes. Even though most entities will be tax exempt, this decision results in economic double taxation without a tax credit. Whether an entity is treated as transparent or opaque for UK tax purposes vary the amount of tax incurred by a UK taxpayer investing in it. (Hardwick, 2013, P.85) Despite these rules being more internationally friendly, they are not yet perfect.
“A partnership, in contrast, is treated as transparent under German income tax law.” (Piltz, Rödder, Bahns, & Schönfeld, 2014, p.12) Therefore, under tax law is not being regarded to generate its own income, only as attributing it to the partners. “Germany does not have an equivalent to the US check-the-box rules under which partners can elect to be taxed as transparent or an opaque entity.” (Piltz, Rödder, Bahns, & Schönfeld, 2014, p.12) If a partner is a person, then they are subject to income tax, whereas if the partner is a legal entity then they are subject to corporate income tax. [In Germany the] distribution of profits to the partners does not trigger any additional taxation.” (Piltz, Rödder, Bahns, & Schönfeld, 2014, p.12) In addition, the choice of entity also has no significant tax burden. “At the level of the German entity the legal form makes no difference to the tax burden – but it does make a difference to who owes the tax.” (Piltz, Rödder, Bahns, & Schönfeld, 2014, p.15)
4.0 Check-The-Box Regime
“On December 17, 1996, the Internal Revenue Service (the “IRS” or the “Service”) and the Treasury Department issued final entity classification regulations (hereinafter referred to as the “check-the-box regulations”) under 7701 of the Internal Revenue Code that allow taxpayers to elect to treat most business entities for U.S. federal income tax purposes either as a corporation or a partnership (if the entity has two or more members), or to disregard the entity (if the entity has one member).” (Benson, Rollinson, O’Connor & Sunghak, 1997, p.363) Check-the-box is an elective regime under which business entities (whether corporate or unincorporated associations or a foreign entity) may elect whether to be treated as a corporation or pass through entity. This classification remains for a period of 5 years. “Eighty types of foreign business entities are specifically excluded from this elective system and are treated per se as corporations [(mostly those on stock exchange)].” (Benson, Rollinson, O’Connor & Sunghak, 1997, p.363) The benefits of filling in Form 8832 are simplification and lower costs when compared to the prior four-factor regime.
5.0 Corporate Social Responsibility Vs the Burden of Tax
As entities are separated by their ‘corporate veil’ corporate law also has reporting requirements of profits, therefore Corporate Social Responsibility plays a role along with best practices regarding tax accounting statutory rules. “In Australia, the UK and the US, corporate governance has traditionally focused on the interests of the financial stakeholders.” (Lavermicocca & Buchan, 2015, p.9) Social responsibility is the obligation of management to make decisions and take actions to enhance welfare and interests of the society. “In line with this, directors and managers seek to minimise taxes payable by a company (within the law) and to the extent that they do not, their actions could be considered inconsistent with shareholder objectives.” (Lavermicocca & Buchan, 2015, p.9)
Aggressive tax planning can sometimes be viewed through CSR as companies not paying their fair share of tax. However, the ‘fair share’ argument is based on an assumption that each country or company should pay its ‘fair share’ in tax, however any tax taken from one part of society to give to another can be said to be favouring one group at the expense of another group. Rather lawmakers should focus on the benefits that corporations bring to each country, such as job creation, goods/services provided and charitable efforts. Corporations however cannot unlike individuals personally bare the burden of taxation like an individual can. If you tax a corporation you are effectively taxing other shareholders, employees, customers, suppliers, ect. With that in mind only individuals can bear the corporation’s burden of tax. Then it isn’t then surprising that income tax incorporates these special rules when it comes to the taxation of corporations and their members.
6.0 Tax Competition > Corporate Tax Rate
When considering the tax treatment of entities, we must also consider tax competition, as this factor drives international investments to a country. It is a large incentive for entities to be classified under one country’s regime rather than another. Tax competition can be viewed both widely and closely. For instance, the aggressive competition on a regional basis, is due to logistics getting goods and services from place to place. Whereas, on a country to country basis, it is due to trade/tax agreements and tax incentives. For the UK after Brexit, it would be beneficial to attract new investment through corporations, incentivised by reduced trade barriers and the challenge of increased international competition. (Blake, 2020, p.7) “[Statistics on corporate tax on an international average are commented on by] Chris Morgan, a partner at KPMG, [who said] rates appeared to be levelling off, marking an end to what economists have described as the ‘race to the bottom’ on corporate tax.” (Houlder, 2014, p.1) Reducing corporate tax rates on average would be abolished as per statistics, but now they have stabilized and have slightly increased in 2018 on a worldwide average.
7.0 Retained Profits & Dividend Taxation for Entities
Another argument in favour of freedom of entity choice, would be to avoid inconsistent penalty taxation. “The accumulated earnings tax is a penalty tax levied in addition to the regular corporate income tax and is imposed on any corporation which satisfies two conditions: (1) The corporation accumulated earnings beyond the reasonable needs of the business (referred to as the objective condition) and (2) the corporation is formed or availed of for the purpose of avoiding income taxes with respect to its shareholders (referred to as the subjective condition).” (Bluemenfrucht, 1981, p.1) The US uses this 20% penalty tax, hereby imposed by section 531, is to encourage shareholders to distribute through dividends their accumulated earnings/retained profits. This 20% is also the highest rate attached to dividends. Due to this extra dividend tax, there can be an incentive for shareholders to essentially remove the corporation and elect to be a Limited Liability Company and Check-The-Box to be transparent.
“The TCJA establishes section 199A, a potential deduction of up to 20 percent that may be utilized by passthrough entities.” (Borden, 2018, p.614) Section 199 provides a 20% reduction for individuals conducting business; it can provide an effective tax rate of 29.6%. It is better to change the entity choice if the entity doesn’t meet the requirements to qualify a deduction. If an LLC, then 199A will be important in making this decision, if you are in full distribution then elect to be transparent, if you retain profits then you are better off being a corporation and being taxed at the 21% corporate rate. “The new tax code requires the 20% Section 199A deduction to be calculated for each separate business.” (Neiffer, 2018, p.1)
In Australia, taxing dividends from offshore companies was very complex prior to 1st July 2010, since then two regimes for Controlled Foreign Company (CFC) rules and Div 6AAA (foreign transferor trusts) have made it less complex. Certain dividends from offshore companies are now treated as NANE income in Australia, when the resident shareholder is a company and has more than 10% participation interest. This tax offset is based on the fact that such income would have already been taxed under CFC rules. In the case that Australia does tax the foreign income, then there would be an allowable foreign income tax offset (FITO). “The central purpose of CFC rules is to eliminate deferral [because] of the time value of money, the longer the period of deferral, the closer the effective rate of tax on the foreign income is to the foreign rate.” (Burns, 2006, pp.152-153)
8.0 C & S Corporations
“C corporations, which are governed by Subchapter C of the Internal Revenue Code (IRC), are subject to a corporate-level income tax levied at corporate tax rates. Distributions of income from C corporations to the owners in the form of dividends are taxable. S corporations are governed by Subchapter S of the Internal Revenue Code 1954. An S corporation is a passthrough entity, with all income and dividends being taxed directly to its shareholders.” (Borden, 2018, p.614) C corporations carry disadvantages when compared to an S corporation. “At the top of the list is the potential for double taxation because profits are taxed at the entity level and at the individual level when distributions are made in the form of dividends.” (Zambrano, 2012, pp. 646-647) Being taxed at both the corporate tax plus the tax on dividends, most entities will want to continue to be passthrough entities. (Roger, 2018, p.15)
Whereas, an S corporation avoids the trap of double taxation, and pays lower taxes. “In 2008, the Federal Fiscal Court (Bundesfinanzhof) decided, for the first time, that US S-Corporations are eligible for a reduction of German withholding tax on dividends to 5% under article 10(2)(a) of the Germany-United States Income and Capital Tax Treaty (1989) (the Treaty), overruling a series of contrary Cologne Fiscal Court decisions that only granted a reduction to 15% under article 10(2)(b).” (Resch, 2014, p.1) The corporation will have income, example of a partnership method, taxed at shareholder level not retained profits. Under an S Corporation allocations of the retained profits go directly to shareholders who are taxable on them. Residual gets allocated to the group. S corp allows you to say we have this capital gain and we are going to allocate it to the group who each will be taxed at 20% on their share. Every time an S corporation has allocated retained profits, the cost base of the shareholder is actually raised. To do with the economic double taxation of gains on the disposal of shares. Whereas, if the S corp made a loss instead of a gain, can you allocate the losses of the S corp to the shareholders.
9.0 Treaty Shopping
Tax treaties are an obvious aspect of the income tax system, through their tax relieving nature, most developed countries have entered into tax treaties with trading partners. The growth is exponential, there are now over 3,000 bilateral tax treaties. The primary goals for a tax treaty is to reduce double taxation risks and to ensure income does not escape tax entirely (stateless income). “Reasons as to why taxpayers pursue treaty shopping are: 1. claiming an otherwise unavailable reduction or exemption of withholding taxes in the source state of the income, 2. claiming an otherwise unavailable tax exemption in the residence state, and 3. claiming the benefit of a tax sparing credit.” (Kosters, 2009, p.12) However, by moving a corporation to the US can be considered by the OECD to be treaty abuse. “According to the general rule of interpretation under the Vienna Convention (1969), treaties shall be interpreted in accordance with the ordinary meaning of their terms, taking into account the context and object and purpose.” (Resch, 2014, p.5) Meaning that when reading a treaty, there should be consideration to the Cologne Fiscal Court, in its specific case by case interpretation. Income earned in foreign jurisdictions can result in income being hidden offshore, treaties typically add provisions that govern the exchange of information, permitting tax administrations to obtain information and undertake collections activities. (Neilson, 2018, p.42) “In the global economy, controlled foreign companies (“CFC”) rules must protect the Australian tax base from abuse involving tax havens and preferential regimes but, at the same time, must not hinder Australian multinationals in the establishment of genuine offshore operations.” (Burns, 2006, p.149)
10.0 OECD BEPS Action 2 Direction
This discussion of the relevant tax treatment is not complete until we cover OECD BEPs Action 2. This regime originated to target and neutralise the effects of hybrid mismatch arrangements. However, some policy observations on the hybrid report include concern over its complexity and workability of rules and tax treatment in other jurisdictions that tax authorities must know, therefore increasing the costs for tax administration. “Lack of recognition that a jurisdiction’s hybrid rules or lack thereof are just one part of the jurisdiction’s overall fiscal policy, which has been set to achieve its specific economic aims, and are no different from other tax and nontax levers, e.g., overall corporate tax rate, tax incentives, and legal and fiscal governance.” (Collier, Van Weeghel, Greenfield, Olson, Dewar, Woodhouse, and Collins, 2014, p.60) Therefore, the main issue is whether OECD action should start approaching the policy not from a top-down approach but a bottom-up approach, or none at all. Another consideration from a study by the OECD (2015) empirical analysis estimates that BEPS is responsible for global Corporate Income Tax revenue losses estimated in 2014 to be between USD 100 and 240 billion annually.
11.0 Conclusion
In conclusion, the tax treatment of entities in an international perspective offers more favorable opportunities for tax planning when considering regimes such as Check-The-Box, and more complexity when considering OECD action under BEPs regimes. However, it is not possible to create a perfect tax system, due to the ever changing nature of tax laws in international environments. Key considerations to the approach of entity classification and used in both Germany, the UK, the US and Australia is to rely on what form an entity is in the general law in its home country, and what are the rights and relations these foreign entities have overseas. The status for separate legal personality changes between, jurisdictions, law and the type of entities.
Criteria that can be used to judge the tax system is equity, efficiency, and simplicity. Now for general purposes, the check-the-box allows the freedom to business entities to elect whether to be treated as a corporation or pass through entity; possible making for a simple and efficient tax solution. Alternatively, tax competition as a factor drives international investments to a country. It is also a large incentive for entities to be classified under one country’s regime rather than another due to retained earnings penalty taxation. Simplicity and certainty are required especially to ensure reporting requirements can be easily met, as entities are separated by their ‘corporate veil’ Corporate Social Responsibility plays a role along with best practices regarding tax accounting statutory rules. The primary goals for a tax treaty is to reduce double taxation risks and to ensure income does not escape tax entirely (stateless income). Income earned in foreign jurisdictions can result in income being hidden offshore, treaties typically add provisions that govern the exchange of information, permitting tax administrations to obtain information and undertake collections activities.
12.0 Reference List
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Neiffer, P 2018, ‘Section 199A: The Rules For Entities.(The Farm CPA)’ Top Producer, vol. 35, no. 7.
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Piltz, DJ, Rödder, T, Bahns, J, & Schönfeld, J 2014, Cross-border investments with Germany : tax, legal and accounting : in honour of Detlev J. Piltz , Otto Schmidt, Cologne, Germany.
Resch, R.X. 2014, “Case Closed: Tax Treatment of US S-Corporations under the Germany-United States Income and Capital Tax Treaty – Treaty Benefits for Hybrid Entities”, European Taxation, vol. 54, no. 5, pp. 192.
Roger Russell 2018, ‘Tough decisions for pass-throughs; Accountants may face their own Section 199A issues. (tax practice)’ Accounting Today, vol. 32, no. 3, p. 15,17.
Zambrano, J.M. 2012, “How Changes in Corporate Tax Rate Can Affect Choice of C vs. S Corp”, The Tax Adviser, vol. 43, no. 10, pp. 646-647.