United States: Using a Noncorporate Entity to Effectuate a Cross-Border Combination

Aconventional combination of a U.S. and a non-U.S. corporation can cause serious U.S. tax problems for the shareholders of both entities. Many of these problems do not arise if both entities are acquired by a foreign entity that will function as a holding company and can be treated as a partnership for U.S. tax purposes or, if there is no suitable foreign entity, a Delaware limited liability company. Both privately and publicly held corporations can use this technique.

Some shareholders of a non-U.S. corporation will be reluctant to have the company acquired by a U.S. corporation for stock of the acquiror. The major reason for this reluctance is that dividends paid by a non-U.S. subsidiary to its U.S. parent are subject to U.S. corporate tax. This tax can be offset by foreign tax credits, but the most that can be achieved is a breakeven. But breaking even in this game is not easy.

From the perspective of the shareholders of the U.S. corporation, having it acquired on a tax-free basis by a foreign corporation is difficult if they will own less than 50 percent of the stock of the acquiror?and almost impossible if they will own more stock. Pending legislation aimed at a U.S. corporation engaging in an inversion (becoming a subsidiary of a non-U.S. holding company) may make it more burdensome to accomplish a tax-free acquisition of a U.S. corporation by a foreign corporation and may increase the subsequent U.S. corporate tax.

These problems do not arise if both entities are acquired by a non-U.S. holding entity that can be treated as a partnership for U.S. tax purposes. Such an entity will not be subject to U.S. income tax on dividends paid by its operating subsidiaries. Since it is a holding company with no U.S. business operations, there should be no U.S. tax (other than the U.S. tax now imposed on the U.S. entity). Because the entity is a partnership for U.S. tax purposes, the acquisition does not have to satisfy U.S. reorganization rules to be tax-free to the U.S. shareholders. (The U.S. rules for tax-free contributions of property to a partnership must be satisfied, but they are less rigid than the reorganization rules.) The pending anti-inversion legislation does not apply to an acquisition of a U.S. corporation by a foreign partnership. Most of the U.S. tax objectives of an inversion can be attained with a foreign partnership. If the combination does not work out and must be unwound, the partnership allows this to be accomplished with no U.S. tax at the entity level and with much less U.S. tax at the shareholder level, especially if each investor group receives the stock that it contributed to the entity.

U.S. taxpayers who own an interest in a partnership are subject to tax on their share of partnership income, whether or not distributed. The holding company can avoid "phantom income" by limiting dividends from subsidiaries to its administrative expenses and the amounts to be distributed to its owners. Because its only income is dividends, the fact that its equity is publicly traded will not cause it to be a corporation for U.S. tax purposes.

The "check-the-box" regulations allow most business entities other than conventional U.S. corporations and non-U.S. entities with similar characteristics to elect to be either corporations or partnerships for U.S. tax purposes. The regulations contain a list of approximately 80 non-U.S. jurisdictions; the one entity that can be formed under the laws of each such jurisdiction that must be treated as a corporation for U.S. tax purposes. An election can be made for any other entity, including any Bermudian or Cayman Islands entity.

If no foreign entity is suitable, nearly all of the U.S. tax objectives can be achieved by using a Delaware limited liability company. The only difference is that the non-U.S. corporation will become a "controlled foreign corporation" because all of its stock is owned by a U.S. person. This will not adversely affect the foreign owners, and the effect on the U.S. owners will probably be insignificant if the holding company receives and distributes dividends from its operating subsidiaries.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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