Foreign nationals have several options in choosing which business entity will provide the most advantages. However, not all structures are created equal and although some may present well initially, further analysis shows the potential pitfalls associated with those structures.
A client came to us with some questions regarding Hybrid Entities. Please see below for the conversation.
I. Question
We are foreign nationals of foreign country (“Country X”) planning on starting in a business in the United States (US). Our U.S. advisor recommends that we form a U.S. limited liability company (U.S. LLC) to run our business. Do you agree?
II. Answer
Not always, especially if the U.S. LLC is a hybrid entity that is treated as transparent for US tax purposes but is treated as a corporation for Country X income tax purposes.
III. The Problem – Qualifying for US/Country X Income Tax Treaty Benefits
1. The U.S. LLC is a disregarded entity for U.S. income tax purposes. This means that its income is taxed at the foreign owner (member) level, even if the income is not distributed. Thus, for U.S. tax purposes, the taxpayer is the foreign owner of the LLC.
2. However, Country X treats the U.S. LLC as a corporation (a non-transparent entity) for income tax purposes. Thus, for Country X tax purposes, the taxpayer is the U.S. LLC, a resident of the U.S.
3. This results in a mismatch (or hybrid) in how the U.S.LLC is treated for U.S. and for Country X tax purposes.
4. This mismatch may severely impact a foreign partner’s ability to claim tax treaty benefits to reduce or eliminate U.S. income taxes.
5. To get the benefit of a treaty, the individual or entity claiming a treaty benefit must be a resident for treaty purposes and therefore entitled to treaty benefits.
6. A problem arises because of the mismatch in how the US LLC is classified under US tax law (transparent) and the law of a foreign treaty country (non-transparent).
7. For U.S. tax purposes the taxpayer is the owner of the LLC (a resident of Country X) and for Country X purposes, the taxpayer is the LLC itself (a resident of the U.S.).
8. Similarly, if the LLC is not disregarded but is taxed as a partnership, according to most modern treaties [1] the partnership is ignored for income tax purposes and we have to test whether the partners themselves qualify as residents. (Similar to the analysis above.)
9. For example, Article 1, paragraph 6 of the US-New Zealand treaty provides:
An item of income, profit or gain derived through an entity that is fiscally transparent under the laws of either Contracting State shall be considered to be derived by a resident of a State to the extent that the item is treated for purposes of the taxation law of such Contracting State as the income, profit or gain of a resident.
U.S. source income received by the U.S. LLC, an entity organized under U.S. law, which is treated for New Zealand tax purposes as a corporation and is owned by a New Zealand resident shareholder, is not considered derived by the shareholder of that corporation even if, under U.S. tax laws, the U.S. LLC is treated as fiscally transparent. Instead, the income is treated as derived by the LLC (a non-New Zealand resident).
Therefore, because the income is not derived by a New Zealand resident under the treaty, the foreign partners of the U.S. LLC may not be entitled to treaty benefits.
IV. The Solution – Instead of a U.S. LLC, Use a U.S. Partnership
Here, a more conventional partnership (general or limited) entity may be better because, for tax purposes, a partnership will be either ignored or treated as a flow-through entity, but not as a corporation. Because a partnership is either ignored or treated as a flow-through, in both the U.S. and Country X we would test the residence of the partners. This prevents the hybrid mismatch discussed above and preserves treaty benefits.
Clearly, each client situation is unique and must be thoroughly analyzed before recommending a U.S. LLC or partnership for U.S. operations. Likewise, the treaty must be thoroughly analyzed. Still, practitioners and foreign investors alike should be aware of the possible denial of treaty benefits when using hybrid entities for U.S. operations.
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[1] For example: Belgium, Bulgaria, Denmark, Finland, Germany, Malta, Netherlands, New Zealand, South Africa, Sri Lanka, Sweden, and the United Kingdom.
