What is a check the box election and should a foreign corporation make one?

In our whitepaper, “United States entity considerations in the trump era” we outlined how the check the box regime can impact Australian businesses. While that paper specifically addressed Australian corporate groups the issues discussed have direct relevance to any global business.

When a foreign founder or family that owns an active business moves to the US they need to consider the application the US attribution rules (Controlled Foreign Corporation (CFC) rules and Passive Foreign Investment Company (PFIC) rules) will have on the US taxation of their foreign operations. If proper planning is not undertaken foreign earnings may be double taxed and foreign tax paid may not be able to be offset against US income.

A foreign corporation can avoid double tax and foreign tax credit mismatch issues by making a check-the-box election. A check-the-box election allows foreign corporations to elect their US tax status when the US tax system becomes ‘relevant’ to them.

The US tax system will become ‘relevant’ to a foreign corporation if:

  • the foreign corporation derives US sourced income;
  • the foreign corporation has an obligation to file an income tax or information return in the US; or
  • the owner of a foreign corporation becomes a US tax resident (ie a US Person).

A foreign corporation may wish to make a check the box election to ensure that foreign tax paid by it is creditable to the owner of the corporation in the US. It may also wish to avoid attribution of income under the controlled foreign corporation (CFC) rules or the loss of the long term capital gains tax rate on the transfer of shares in a passive foreign investment company (PFIC).

A foreign corporation will be a CFC if more than 50% of the shares are owned directly, indirectly or constructively by ‘US Shareholders.’ A person will be a ‘US shareholder’ if they own more than 10% of the total voting or value of stock on issue in such foreign company.

A foreign corporation will be a PFIC if it satisfies one of two conditions:

  1. at least 75% of a corporations gross income is income that is derived from passive investments rather than regular business activities; or
  2. at least 50% of a corporations assets are investments that produce income earned from interest, dividends and capital gains.

The check-the-box regulations regime provides default classifications for foreign eligible entities. The default classification for foreign eligible entities is determined by whether a member, doe or does not have limited liability. A foreign eligible entity will be taxed as a corporation for US purposes if all of its members (ie owners) have limited liability; a partnership if it has two or more members and at least one member does not have limited liability; and a disregarded entity (iesole proprietorship) if it has a single owner that does not have limited liability.2
An eligible entity can make a CTB election to elect out of the default classifications to be taxed as either a flow-through tax entity or as a corporation.
If a foreign corporation makes an election after it has been classified under the default rules, such election is a change in classification election and can trigger in a liquidation event. For this reason due care should be taken when making an election.
Accordingly, you should consider making an election if:

  1. you are a foreign corporation and the US tax system is relevant to you;
  2. you wish to be able to take a credit in the US for foreign corporate tax paid; and
  3. you wish to avoid the application of the CFC or PFIC rules.