Inbound investments into the United States

 A session report from the IBA’s 24th Annual US and Europe Tax Practice Trends Conference in Munich

Thursday 11 April 2024

Co-Chairs

Pia Dorfmueller, Dentons, Frankfurt

Lori Hellkamp, Jones Day, Washington, DC

Speakers

Joan C Arnold, Troutman Pepper, Philadelphia

Stuart Chessman, Vivendi, New York

Fabio Chiarenza, Gianni & Origoni, Rome

Wiebe Dijkstra Wiebe, De Brauw Blackstone Westbroek, Amsterdam

Floran Ponce, Lenz & Staehelin, Geneva

Reporter

Constanze Wetzel, Noerr, Munich

Introduction

The panel discussed the complexities surrounding investment in the United States (US) through hybrid entities, providing diverse perspectives on the matter. Each speaker offered insights into recent developments concerning these entities in their respective jurisdictions.

Panel discussion

Investing in the US when hybrid entities are involved

US tax basics

Joan C Arnold explained that if a foreign corporation is engaged in trade or business in the US directly via a branch or permanent establishment in the US, it is required to file US tax returns.

Further, the foreign corporation has to pay 21 per cent US corporate income tax and an additional annual US branch profits tax, which applies irrespective of repatriations. The branch profits tax is calculated using a complicated formula, taxing after-tax earnings and profits that are not reinvested in business assets in the US, imposing a 30 per cent tax rate. Arnold concluded that she would, therefore, generally advise against investing into the US through a branch or permanent establishment.

Arnold mentioned that she prefers hybrid structures involving a US limited liability corporation (LLC) as an investment vehicle for inbound investments into the US because they can be utilised in two different ways. Although a legally separate entity, a US LLC is, by default, a disregarded entity for US tax purposes unless it makes an explicit election to be taxed as a corporation. If the LLC elects to be treated as a corporation, the LLC is subject to US corporate tax and distributions made by it are subject to US withholding tax. If no election is made, the profits of the LLC are, due to its treatment as a disregarded entity, generally subject to US corporate income tax, as well as the branch profits tax at the level of the foreign corporation.

New Dutch classification rules for foreign entities

The current entity classification rules will be replaced with New Dutch classification rules as of 1 January 2025. Key features include that Dutch partnerships will be treated as tax transparent by default. However, Wiebe Dijkstra pointed out that uncertainty remains, since partnerships may be qualified as mutual funds, which may nonetheless be treated as opaque if they inter alia are regulated investment funds.

The new system will consist of a two step-approach: firstly, it should be assessed whether a foreign entity is comparable to a Dutch entity and, if so, it will attract the same entity classification as the relevant Dutch entity. Secondly, if the foreign entity is not comparable and is tax resident outside the Netherlands, the foreign tax qualification will generally be followed (symmetrical method). If a non-comparable foreign entity is a Dutch tax resident, it will be treated as opaque (fixed method). US LLCs will still be treated as tax opaque from a Dutch tax perspective, as they are similar to a Dutch private limited liability company.

German classification rules

Pia Dorfmueller reported that due to a circular published in 2004 by the German Federal Ministry of Finance, each US LLC must be classified individually taking into consideration a catalogue of 12 criteria, for example, centralised management and representation, limited liability, free transferability of interests, allocation of profits, rules governing capital contributions and capital preservation, perpetual duration of the entity, profit distribution and formal requirements for organisation. The classification depends on whether the overall pattern of the LLC’s characteristics is more equivalent to a German corporation or a partnership.

Dorfmueller remarked that according to recent tax court cases, the criterion regarding the obligations concerning capital contributions is of limited significance, as a German corporate body can also be established with minimal capital.

Swiss corporations investing in a US LLC

The tax treatment of US LLCs in Switzerland is controversial, according to Floran Ponce. In general, foreign entities are compared and classified based on the most similar Swiss legal entity for tax purposes. According to Ponce, in most cases a US LLC would, therefore, be treated as opaque. Regarding dividends, US LLCs can apply for Swiss participation relief.

However, Swiss Supreme Court judgments state that: (1) the US tax treatment and/or (2) double taxation issues (no double non-taxation) should be considered. As a result, LLCs could also be tax transparent. Ponce recommended confirming the tax treatment via the relevant tax rulings.

Italian corporations investing in the US via a US LLC

Fabio Chiarenza noted that foreign entities are generally seen as opaque in Italy. If a US LLC is transparent in the US but opaque in Italy, it is considered to be a reverse hybrid entity from an Italian perspective. Interest paid by US corporate subsidiaries to such an LLC may not be deductible under anti-hybrid rules in the US and may be subject to a 30 per cent US tax without treaty access (and the same could apply to dividends received by the LLC). Profits repatriated to the Italian parent are considered dividends for Italian tax purposes and are taxed accordingly.

An LLC treated as opaque for US tax purposes is also opaque for Italian tax purposes.

According to the principles introduced by the Italian tax reform as of 9 August 2023, a foreign entity’s tax status under local law shall be decisive, ie, the classification follows its country of incorporation/residence. Thus, the treatment of a US LLC under Italian tax law will depend on its US tax treatment.

Dutch corporations investing in the US via a tax transparent US LLC

A different qualification of a US LLC from a Dutch tax perspective (opaque) and from a US tax perspective (transparent), by itself, does not affect the ability of the LLC to apply for the Dutch participation exemption, according to Dijkstra. But it creates withholding taxation and hybridity issues. If for example a Dutch corporation holds a transparent US LLC that receives interest and dividend income from its US corporate subsidiaries, interest and dividends are generally deemed paid directly to the Dutch corporation from a US perspective and should, therefore, be subject to the applicable US withholding taxes. Since this income is not attributed to the Dutch corporation from a Dutch tax (treaty) perspective, however, the tax treaty between the US and the Netherlands may not be applicable.

The possible solutions according to Dijkstra, are: (1) shifting the US LLC’s tax residency to the Netherlands by reincorporating as a Dutch legal entity, which would then allow for interest and dividends to be paid from its US subsidiaries (assuming all other requirements are satisfied, including limitation on benefits (LOBs)), using the Dutch–US tax treaty, due to its then Dutch corporate tax status; (2) converting the LLC into a US corporation, whether via a formal conversion or a ‘check the box’ election; or (3) converting it into a limited partnership, which offers flexibility under the new Dutch classification rules (transparent qualification from a Dutch tax perspective).

Financing a US investment: transfer pricing rules in Germany and Italy

In Germany, new rules were introduced for cross-border intercompany financing into Germany, imposing additional hurdles for interest deduction in related party financing transactions. Dorfmueller explained that group ratings, economic necessity and repayment probability tests are now mandatory for deduction eligibility. Intercompany financing is now deemed low function and low risk for transfer pricing purposes, requiring the application of the cost-plus method.

Italian transfer pricing regulations align with the Organisation for Economic Co-operation and Development’s (OECD) principles. Chiarenza highlighted implicit support for rating analysis in Italy, citing the Italian Supreme Court’s acceptance of interest-free loans under economic duress, affirming their compliance with Italy’s transfer pricing regulations.

The one per cent stock buyback excise tax and intergroup financing

Publicly traded US corporations and certain publicly traded foreign corporations are subject to a one per cent excise tax on buybacks of stock exceeding an annual de minimis amount of $1m. This excise tax is non-deductible and is not covered by tax treaties.

Shortly after enactment, the Internal Revenue Service (IRS) issued a notice and expanded the scope of the excise tax to share repurchases by non-US listed multinationals if a US affiliate ‘funds’ the repurchase. The notice contained a ‘per se’ rule stating that a principal purpose of avoiding the excise tax is generally met in all cases in which the foreign corporation acquires or repurchases stock within two years of receiving funding from a US affiliate. According to Stuart Chessman, this proposed rule was widely criticised.

In April 2024, draft regulations were published in which the strict ‘per se’ rule was replaced with a rebuttable presumption that applies only to a narrower set of ‘downstream’ funding options occurring within a two-year timeframe. Chessman pointed out that despite the per se rule being narrowed significantly, the general funding rule remained in place, which still applies if a principal purpose to avoid the excise tax is present. It may be difficult, depending on how the tax is enforced, for a taxpayer to present facts and circumstances that establish that avoiding the excise tax was not a principal purpose of the funding.

Conclusion and final remarks

The panel concluded that US LLCs offer a viable option for foreign corporations investing in the US. They stressed the importance of considering various options, treaty eligibility and the provisions based on the residence countries involved, as well as the hybrid status. Furthermore, they pointed out that it is crucial to understand the implications of the US excise tax and recent law changes, which require careful consideration by tax advisors across the relevant jurisdictions.