Synopsis:

The 2017 965 Transition Tax confiscated the pensions of a large numbers of Canadian residents. The ongoing GILTI rules have made it very difficult for small business corporations to be used for their intended purposes in Canada.

The power to regulate is the power to destroy! That's why the regulatory process should require careful consideration of how and to whom regs apply. It's time for Treasury to consider "A Simple Regulatory Fix for Citizenship Taxation" https://t.co/6dUqXjtUNo via @SEATNow_org

— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) June 27, 2021

Canadian corporations should NOT be deemed (under the Treasury entity classification regulations) to be “per se” corporations. The reality is that corporations play different roles in different tax and business cultures. Corporations in Canada have many uses and purposes, including operating as private pension plans for small business owners (including medical professionals).

Deeming Canadian corporations to be “per se” corporations means that they are always treated as “foreign corporations” for the purposes of US tax rules. This has resulted in their being treated as CFCs or as PFICs in circumstances which do not align with the purpose of the CFC and PFIC rules.

The 2017 965 Transition Tax confiscated the pensions of a large numbers of Canadian residents. The ongoing GILTI rules have made it very difficult for small business corporations to be used for their intended purposes in Canada.

Clearly Treasury deemed Canadian Controlled Private Corporations to be “per se” corporations without:

1. Understanding the use and role of these corporations in Canada; and

2. Assuming that ONLY US residents might be shareholders in Canadian corporations. As usual, the lives of US citizens living outside the United States were not considered.

These are the problems that inevitably arise under the US citizenship-based AKA extraterritorial tax regime, coupled with a lack of sensitivity to how these rules impact Americans abroad. The US citizenship-based AKA extraterritorial tax regime may be defined as:

The United States imposing worldwide taxation on the non-US source income of people who are tax residents of other countries and do not live in the United States!

It is imperative that the United States transition to a system of pure residence-based taxation!

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Introduction

The United States imposes a separate and more punitive tax system on US citizens living outside the United States than on US residents. There are numerous examples of this principle – a principle that is well understood (but not directly experienced) by tax preparers.

The US tax system operates through a combination of laws, Treasury Regulations, enforcement by the tax compliance community and IRS administration. There are many instances where the extraterritorial application of the US tax system results in absurdities, that are very damaging to those who try their best to comply with those laws.

Treasury regulations have an enormous impact on how the Internal Revenue Code applies to Americans abroad. In a previous paper coauthored with Dr. Alpert and Dr. Snyder, we described how Treasury could provide “A Simple Regulatory Fix For Citizenship Taxation“. Treasury regulations can be extremely helpful to Americans abroad or extremely damaging. It is therefore crucial that Treasury consider how its regulations would/could impact the lives of those Americans abroad attempting compliance with the US extraterritorial tax regime. In some cases it may be appropriate to have different regulations for resident Americans than for Americans abroad.

Treasury has demonstrated that it can be very helpful

Although this post will focus on difficulties, it’s important to note that Treasury has demonstrated that it can be very helpful to Americans abroad. It has interpreted the Internal Revenue Code in ways that have mitigated what could have been extreme damage. Here are two recent examples from the GILTI context where Treasury:

– interpreted the 962 Election to allow individuals to receive the 50% deduction in GILTI income inclusion that was allowed to corporations; and

– interpreted the Subpart F rules to mean that ALL income earned by a CFC should be entitled to the high tax exclusion

Clearly some of the news coming from Treasury has been good!

The power to regulate is the power to destroy

This post provides examples of how certain Treasury regulations contribute to the application of the United States extraterritorial tax regime. The examples are found in the following two categories of regulations:

Category A: Foreign Trusts – The Form 3520A Penalty Fundraiser – Regulations That Are Unclear Resulting In Penalties

Category B: Business Entities Designated as “per se” Corporations – Creating CFCs In Unreasonable Circumstances (Canadian Controlled Private Corporations) – Regulations That Are Clear But Over-inclusive

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Category A: Foreign Trusts – The Form 3520A Penalty Fundraiser – Regulations That Are Unclear Resulting In Penalties

Advocacy and diligence can pay off: "Great News For IRS Form 3520-A Filers Effecting Thousands Of Taxpayers" https://t.co/63MhPJun2c via @TaxConnections

— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) June 27, 2021

As has been widely discussed at Tax Connections (and other venues), large numbers of Americans abroad were assessed $10,000 USD penalties (presumably computer generated) for issues surrounding the filing of form 3520A. Fortunately the IRS recognized its error and those penalties either have been or will be abated. An excellent description of what happened is in this summary by Gary Carter. The assessment of the penalties is the “visible” part of the problem. But, the larger problem was individuals filing Form 3520 for things that probably do NOT meet the definition of a “trust” under Treasury’s entity classification regulations.

In most cases the entity classification rules found in the Treasury Regulations do NOT provide sufficient guidance for what non-US entities qualify as trusts. The Treasury regulations do NOT specify whether tax favoured accounts in Canada (and other countries) qualify as trusts or not. The uncertainty has resulted in many people filing Form 3520 for things that probably do NOT meet the definition of “Trust”. (To be fair, Treasury did attempt to provide some relief for non-US retirement plans in Rev. Proc 20-27.)

(It would make good sense for the regulations defining trusts to exempt any non-US plan, that is exempt from reporting under the FATCA IGAs. This would be consistent with the purpose of the reporting rules in IRC 6048 and allow Treasury to leverage work that it has already done.)

To be clear, it is the lack of clear application to non-US retirement plans that creates the ambiguity.

Category B: Business Entities Designated as “per se” Corporations – Creating CFCs In Unreasonable Circumstances (Canadian Controlled Private Corporations) – Regulations That Are Clear But Over-inclusive

It is a mistake to presume that the manner in which a foreign entity is classified for local tax purposes is the same as it is classified for US tax purposes. It is entirely possible for a business to be classified in one way locally and in another way for US tax purposes.

Who an entity is for legal purposes may be different from what an entity is for US tax purposes. Naturally whether the entity is "US" or "foreign" is a further complicating factor. Some are per se corporations and some can elect to be ignored/disregarded. https://t.co/R2Dnuue5wN pic.twitter.com/ZJfDEthITa

— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) June 29, 2021

“Corporations” are not defined in the Internal Revenue Code 7701(a)(3) which tells us only that:

(3)Corporation

The term “corporation” includes associations, joint-stock companies, and insurance companies.

This does not give us a definition of a corporation. Hence, we look to the relevant Treasury Regulations. The Regulations which took effect on January 1, 1997 (a particularly good analysis is here) provide a regime where (with respect to both US and non-US AKA foreign entities):

– Certain business entities (both US and non-US) are “per se” (deemed) corporations and subject to taxation as corporations;

and

– Certain business entities (both US and non-US) can elect to be corporations and are subject to taxation as corporations only if they elect to be corporations. (Otherwise, for the purposes of taxation they are treated as partnerships or as disregarded entities.)

Note that only corporations can be subject to the Subpart F (including transition tax and GILTI) and the PFIC regimes! Hence, there are clear disadvantages to a non-US entity being treated as a “corporation” under the Treasury entity classification regulations. The advantages or disadvantages to being a non-US corporation vary with the circumstances of the taxpayer. All circumstances must be considered including whether the taxpayer is:

– a US resident; or

– a US citizen living outside the United States trying to run a small business.

That said, it is clearly very bad for a non-US business entity to be deemed (for US tax purposes) to be a “per se corporation”. It will be forced to accept the status of being a corporation for US tax purposes. This means that the US person shareholder(s) will have to deal with the complexity and horror of the possible application of the Subpart F (GILTI) rules or the PFIC regime along with the costly compliance requirements.

These requirements include:

– Complicated Forms (5471, 8865, 8621, etc.) ; and

– The high cost of paying a a qualified tax preparer to accurately complete the forms.

26 CFR § 301.7701-2 – Business entities; definitions – How They Apply To Foreign Corporations

In enacting the regulations Treasury appears to have “scoured the world”, with a view to deciding which kinds of business entities, in which countries should be deemed to be “per se corporations” and therefore subject to US taxation as “Foreign Corporations”. The regulation includes an impressive list*. For the purposes of this post, I intend to focus on a comparison of Australia, the United Kingdom and Canada.

According to the regulations the following are deemed to be “per se” corporations:

Per Se Corporation: “Australia, Public Limited Company” (Note the focus on “Limited Liability”)

Types of companies in Australia:

There are two main types of companies in Australia, proprietry (private) and public companies. The most common type of company in Australia is the proprietary company (often signified by the “Pty” at the end of the company name).

https://secure.registeracompany.com.au/faq/company-basics.cfm

Note that the “per se” designation applies to the Public Limited Company.

Per Se Corporation: “United Kingdom, Public Limited Company” (Note the focus on “Limited Liability”)

Type of companies in the UK:

There are 8 types of companies in the UK: public limited company (PLC); private company limited by shares (LTD); company limited by guarantee; unlimited company (UNLTD); Limited Liability Partnership (LLP); Community Interest Company; Industrial and Provident Society (IPS) and finally, Royal Charter (RC).

https://www.companyaddress.co.uk/post/38

Note that the “per se” designation applies to the Public Limited Company.

Per Se Corporation: “Canada, Corporation and Company” (Note the exception for “a Nova Scotia Unlimited Liability Company (or any other company or corporation all of whose owners have unlimited liability pursuant to federal or provincial law)”

Types of companies in Canada:

Corporation in Canada

From the beginning, it is good to know that a corporation is a separate legal entity from its proprietors. The stockholders are not responsible for the company’s obligations or debts, as the only interest regards the value of their investments. A private corporation in Canada can be registered by one or more individuals, but it is good to know that the majority of the directors should domiciliate in Canada. Such an entity cannot trade shares freely. As for the public corporation, this is subject to listed shares to the public, in accordance with the rules and regulations mentioned in the Ontario Securities Act. No matter the type of company you are interested in, our company formation agents in Canada can guide each entrepreneur when preparing the documents and applying for special permits and licenses. Corporations must also register for VAT in Canada.

https://www.canadacompanyformation.com/types-of-companies-in-canada

Note that this description does distinguish between public and private companies. It is not clear why the Treasury Regulations do NOT make the distinction among Canadian companies. This is because Canadian corporations can be used for a variety of purposes with a large range in the number of shareholders. At a minimum it would seem reasonable to distinguish between Canadian Controlled Private Corporations (which often play the same role as a US LLC) and Canadian public companies. Yet, the Treasury regulations make no such distinction.

Why are some non-US companies deemed to be per so corporations and others not?

The criterion for non-US companies appears to be based on the “liability” of the owners.

As noted by one commentator:

For Foreign Entities the liability of the owner is/are relevant:

Partnership (or, in the case of single owner entities, disregarded) status is the default classification for a foreign eligible entities only where at least one of the organization’s members has personal liability for the debts of the organization; otherwise, corporate status is the default classification. The question of member liability for an organization’s debts is determined solely by reference to the applicable local statute or law under which the entity is organized. The final regulations clarify that personal liability exists where a member is personally liable for all or any portion of an organization’s debts and that an entity’s organizational documents may be relevant if local law permits the entity to specify in those documents whether members have limited liability.

http://pmstax.com/part/bull9612.shtml

For US entities, the liability of the owners is NOT relevant!

This leads to the conclusion that:

“The effect of these rules is that a U.S. limited liability company (LLC) or limited liability partnership (LLP) is treated by default as a partnership (or disregarded entity if it has only one owner), whereas a foreign LLP is treated by default as a corporation (if, as is generally the case, all its members have limited liability).”

https://en.wikipedia.org/wiki/Entity_classification_election

The Treasury Regulations Discriminate Against US Citizens Living In Canada By Unjustifiably Treating (with few exceptions) Canadian Corporations As “Per Se” Corporations

An individual US resident might create an LLC (Limited Liability Corporation) for the purposes of creating limited liability.

An individual Canadian resident might create a Canadian Controlled Private Corporation (in the Province Of Ontario) for creating limited liability.

Yet a single shareholder Canadian Controlled Private Corporation is treated as a corporation for US tax purposes when the equivalent in the USA could be treated as a “disregarded entity”.

The Canadian resident, was through the 2007 entity regulations, forced into a situation where he would be subject to the Subpart F rules generally and the 2017 Transition Tax and GILTI specifically. The Canadian resident has been forced into Form 5471 Hell and must bear the punitive tax treatment and crippling compliance costs. Yet the US resident, in similar circumstances, has the choice of being treated as a domestic corporation or as a disregarded entity.

Furthermore, residents of Australia and the UK appear to have a greater range of corporate options which allow them to escape the per se corporation classification. It’s as though Treasury imagines that Canadian corporations can never be small single shareholder or family corporations and are always large companies used to generate active business income.

Canadian corporations should NOT be deemed to be “per se” corporations. The reality is that corporations play different roles in different tax and business cultures. Corporations in Canada have many uses and purposes, including operating as private pension plans for small business owners (including medical professionals).

Deeming Canadian corporations to be “per se” corporations (under the Treasury entity classification regulations) means that they are always treated as “foreign corporations” for the purposes of US tax rules. This has resulted in their being treated as CFCs or as PFICs in circumstances which do not align with the purpose of the CFC and PFIC rules.

The 2017 965 Transition Tax confiscated the pensions of a large numbers of Canadian residents. The ongoing GILTI rules have made it very difficult for small business corporations to be used for their intended purposes in Canada.

Clearly Treasury deemed Canadian Controlled Private Corporations to be “per se” corporations without:

1. Understanding the use and role of these corporations in Canada; and

2. Assuming that ONLY US residents might be shareholders in Canadian corporations. As usual, the lives of US citizens living outside the United States were not considered.

These are the problems that inevitably arise under the US citizenship-based AKA extraterritorial tax regime, coupled with a lack of sensitivity to how these rules impact Americans abroad. The US citizenship-based AKA extraterritorial tax regime may be defined as:

The United States imposing worldwide taxation on the non-US source income of people who are tax residents of other countries and do not live in the United States!

It is imperative that the United States join the world and move to a system of pure residence-based taxation!

_____________________________________________________________________________________

*Appendix – (8) Certain foreign entities that are deemed to be corporations per se

“(i) In general. Except as provided in paragraphs (b)(8)(ii) and (d) of this section, the following business entities formed in the following jurisdictions:

American Samoa, Corporation
Argentina, Sociedad Anonima
Australia, Public Limited Company
Austria, Aktiengesellschaft
Barbados, Limited Company
Belgium, Societe Anonyme
Belize, Public Limited Company
Bolivia, Sociedad Anonima
Brazil, Sociedade Anonima
Bulgaria, Aktsionerno Druzhestvo.
Canada, Corporation and Company
Chile, Sociedad Anonima
People’s Republic of China, Gufen Youxian Gongsi
Republic of China (Taiwan), Ku-fen Yu-hsien Kung-szu
Colombia, Sociedad Anonima
Costa Rica, Sociedad Anonima
Cyprus, Public Limited Company
Czech Republic, Akciova Spolecnost
Denmark, Aktieselskab
Ecuador, Sociedad Anonima or Compania Anonima
Egypt, Sharikat Al-Mossahamah
El Salvador, Sociedad Anonima
Estonia, Aktsiaselts
European Economic Area/European Union, Societas Europaea
Finland, Julkinen Osakeyhtio/Publikt Aktiebolag
France, Societe Anonyme
Germany, Aktiengesellschaft
Greece, Anonymos Etairia
Guam, Corporation
Guatemala, Sociedad Anonima
Guyana, Public Limited Company
Honduras, Sociedad Anonima
Hong Kong, Public Limited Company
Hungary, Reszvenytarsasag
Iceland, Hlutafelag
India, Public Limited Company
Indonesia, Perseroan Terbuka
Ireland, Public Limited Company
Israel, Public Limited Company
Italy, Societa per Azioni
Jamaica, Public Limited Company
Japan, Kabushiki Kaisha
Kazakstan, Ashyk Aktsionerlik Kogham
Republic of Korea, Chusik Hoesa
Latvia, Akciju Sabiedriba
Liberia, Corporation
Liechtenstein, Aktiengesellschaft
Lithuania, Akcine Bendroves
Luxembourg, Societe Anonyme
Malaysia, Berhad
Malta, Public Limited Company
Mexico, Sociedad Anonima
Morocco, Societe Anonyme
Netherlands, Naamloze Vennootschap
New Zealand, Limited Company
Nicaragua, Compania Anonima
Nigeria, Public Limited Company
Northern Mariana Islands, Corporation
Norway, Allment Aksjeselskap
Pakistan, Public Limited Company
Panama, Sociedad Anonima
Paraguay, Sociedad Anonima
Peru, Sociedad Anonima
Philippines, Stock Corporation
Poland, Spolka Akcyjna
Portugal, Sociedade Anonima
Puerto Rico, Corporation
Romania, Societate pe Actiuni
Russia, Otkrytoye Aktsionernoy Obshchestvo
Saudi Arabia, Sharikat Al-Mossahamah
Singapore, Public Limited Company
Slovak Republic, Akciova Spolocnost
Slovenia, Delniska Druzba
South Africa, Public Limited Company
Spain, Sociedad Anonima
Surinam, Naamloze Vennootschap
Sweden, Publika Aktiebolag
Switzerland, Aktiengesellschaft
Thailand, Borisat Chamkad (Mahachon)
Trinidad and Tobago, Limited Company
Tunisia, Societe Anonyme
Turkey, Anonim Sirket
Ukraine, Aktsionerne Tovaristvo Vidkritogo Tipu
United Kingdom, Public Limited Company
United States Virgin Islands, Corporation
Uruguay, Sociedad Anonima
Venezuela, Sociedad Anonima or Compania Anonima
(ii) Clarification of list of corporations in paragraph (b)(8)(i) of this section –

(A) Exceptions in certain cases. The following entities will not be treated as corporations under paragraph (b)(8)(i) of this section:

(1) With regard to Canada, a Nova Scotia Unlimited Liability Company (or any other company or corporation all of whose owners have unlimited liability pursuant to federal or provincial law).

(2) With regard to India, a company deemed to be a public limited company solely by operation of section 43A(1) (relating to corporate ownership of the company), section 43A(1A) (relating to annual average turnover), or section 43A(1B) (relating to ownership interests in other companies) of the Companies Act, 1956 (or any combination of these), provided that the organizational documents of such deemed public limited company continue to meet the requirements of section 3(1)(iii) of the Companies Act, 1956.

(3) With regard to Malaysia, a Sendirian Berhad.

(B) Inclusions in certain cases. With regard to Mexico, the term Sociedad Anonima includes a Sociedad Anonima that chooses to apply the variable capital provision of Mexican corporate law (Sociedad Anonima de Capital Variable).

(iii) Public companies. For purposes of paragraph (b)(8)(i) of this section, with regard to Cyprus, Hong Kong, and Jamaica, the term Public Limited Company includes any Limited Company that is not defined as a private company under the corporate laws of those jurisdictions. In all other cases, where the term Public Limited Company is not defined, that term shall include any Limited Company defined as a public company under the corporate laws of the relevant jurisdiction.

(iv) Limited companies. For purposes of this paragraph (b)(8), any reference to a Limited Company includes, as the case may be, companies limited by shares and companies limited by guarantee.

(v) Multilingual countries. Different linguistic renderings of the name of an entity listed in paragraph (b)(8)(i) of this section shall be disregarded. For example, an entity formed under the laws of Switzerland as a Societe Anonyme will be a corporation and treated in the same manner as an Aktiengesellschaft.”