ENTITY CLASSIFICATION Kimberly Blanchard TLHE SIGNIFICEANCE OF GAL Many countries employ the term nerships, whether general or lim - “legal personality” to differentiate ited partnerships, might be con - an entity treated as a separate sidered to possess the attribute corporate taxpayer from a tax- of legal personality, and if so transparent partnership. In these might be treat ed as corporations countries it is sometimes said that for tax purposes in the client’s a corporation has legal person - country of residence. This hybrid ality, whereas a partnership does result can raise a variety of tax not. The author first encountered problems, including the loss of the term legal personality in the treaty benefits otherwise avail - course of advising foreign clients able, 1 the potential for timing and who were considering invest - character mismatches, and the ments in U.S. partnerships. The potential loss of credibility or concern raised by their non-U.S. exemption at home for U.S. taxes tax advisors was that U.S. part - paid by the nonresident partner. 4 BUSINESS ENTITIES March/April 2016 FOR U.S. TAX PURPOSES WHILE THE CONCEPT OF LEGAL PERSONALITY REMAINS AN IMPORTANT FACTOR IN MANY OTHER COUNTRIES, THE UNITED STATES HAS ABANDONED ANY CONCEIT THAT IT MATTERS TO ENTITY CLASSIFICATION FOR TAX PURPOSES. BUSINESS ENTITIES 5 Background term at all. The resulting tension In researching the issue, it soon became between tax systems can give rise to clear that virtually every type of U.S. hybrid entities, frustrating interna - entity that exists today, including a tional efforts to eliminate hybridity in simple general partnership, probably order to minimize classification con - has what many other countries would flicts and the resulting possibility of view as legal personality. Not only is either double taxation or “homeless the construct of legal personality irrel - income.” evant to U.S. tax classification rules; BEPS Project. This is a timely top - the construct barely survives as a mat - ic–the OECD recently completed a ter of U.S. commercial law. Already by monumental project, referred to as the the year 1928, papers presented at a Base Erosion and Profit Shifting legal symposium in Chicago on the (BEPS) project, to eliminate homeless subject of business entities illustrated income by tackling 15 areas where tax that the concept was beginning to lose rules might be harmonized or its meaning. 2 Over time, the conceit changed. 6 One of these 15 projects that in order to be a partnership for involved hybrid entities, and others U.S. commercial law purposes, an enti - implicate the subject of hybridity. ty must lack legal personality, was There is no question that one of the abandoned as a quaint artifact of an major drivers of the BEPS project was earlier age. the perception among many countries In one sense, U.S. tax law recognizes that the U.S. “check-the-box” entity that corporations, but not partnerships, classification rules 7 constitute one of have something we might call “legal the principal evildoers in fomenting personality.” A state law corporation homeless income. But natural hybrid - will always be taxed as a corporation; ity, which existed before and after the it cannot elect to be treated as a part - check-the-box regulations, is far more nership or other form of entity (putting common than many countries aside special tax regimes such as RICs, acknowledge. It arises in part from the REITs, and S corporations). Moline insistence by many countries that only Properties 3 stands for the proposition their own entity tax classification cri - that the mere act of incorporating a teria represent the “correct” approach. corporation creates a separate legal The hybridity that results when in legal classification. Legal personal - person that will generally be respect - one country classifies an entity as a ity, or something like it, is one criteri - ed as separate from its owners for all corporation and another country on that many countries use to classify tax purposes, absent sham or “piercing classifies the same entity as a part - entities. Because U.S. tax rules do not the corporate veil.” A domestic corpo - nership would be rarely encountered give effect to the existence or non-exis - ration is a taxpayer and a resident of if all countries adopted the approach tence of legal personality, this can result the United States for all tax and treaty set out in an earlier OECD report on in hybridity without any taxpayer plan - purposes, whereas a partnership is nei - treaties and partnerships. 8 That ning at all. The legal personality crite - ther. 4 But these are the legal results report recommended that the source rion is particularly pernicious in those that follow from incorporating a cor - country give effect to the taxation of countries that view it as a “superfactor” poration; they do not follow from any the partners in their home country, sufficient without more to require clas - conceit that only a corporation pos - ignoring the treatment of the entity sification as an opaque corporation. sesses what one might call legal per - in the source country and in the This article will undertake to sonality. country where the entity is formed. describe the concept of legal person - In a recent compendium on the sub - Unfortunately, the 1999 OECD report ality and examine the possible reasons ject of entity classification under was lim ited to treaty interpretation why it is often used as a tool for enti - treaties, published by the Internation - and therefore does not apply general - ty classification. It will also review al Fiscal Association (IFA), 5 about half ly. Moreover, many countries have some practical problems that arise of the 40 responding countries men - reserved on the report’s recommen - when countries take different views on tioned legal personality as an impor - dation and will not follow it. the significance of legal personality. tant factor in classifying entities for This article is not about entity clas - tax purposes. The other half, including sification generally, but only about how the United States, did not mention the the concept of legal personality is used I. What is “Legal Personality”? A. In General. A discussion of the KIMBERLY BLANCHARD is a tax partner in New York office of Weil, Gotshal & Manges LLP. Her practice encom - topic of legal personality ought to passes a variety of largely international transactions involving corporate acquisitions and mergers, internal restruc - turings, business formations, and joint ventures. An earlier version of this article was presented at the New York begin by defining what that term University School of Law Spring 2015 Colloquium on Tax Policy and Public Finance and at the Tax Review Club. means. Unfortunately, there appears to 6 BUSINESS ENTITIES March/April 2016 ENTITY CLASSIFICATION authoritative treatises 11 for the propo - person could be sued. This made sense sition that to have legal personality when most businesses were sole pro - means “to be capable of having legal prietorships or informal partnerships rights and duties within a certain legal of a few persons known well to one system, such as to enter into contracts, another. In those cases, the individuals sue, and be sued. Legal personality is were liable for the debts of and claims a prerequisite to legal capacity, the abil - against their business. For various rea - ity of any legal person to amend (enter sons that won’t be explored here, into, transfer, etc.) rights and obliga - around the time of the Industrial Rev - tions.” Under the common law, legal olution people stated to form corpo - personality consisted of five legal rations that afforded limited liability rights: for their owners. As long as only indi - 1. The right to own property (includ - viduals could be sued, there was no ing money). legal remedy if the corporation broke 2. The right to make and sign con - the law or harmed another person. 14 tracts. The owners were protected and the 3. The right to sue and be sued (i.e., to corporation, not being human, could - enforce contracts). n’t be sued. In order to solve this prob - 4. The right to hire employees. lem, the concept of legal personality 5. The right to make by-laws for self- was extended to corporations. governance. B. The Significance of Limited Lia - One might distinguish between bility to Legal Personality. While this “legal personality” in the abstract and brief history illustrates the link “separate legal personality” in the sense between limited liability of an entity’s of an entity having a legal personality owners and the development of legal separate and distinct from that of its personality, today many countries rec - owners. That is, it seems possible that ognize that an entity that does not con - an entity such as a partnership could fer limited liability upon its owners, have legal personality and yet not pos - or at least not to all its owners, can sess a legal personality separate from have separate legal personality. For its partners. However, most countries these countries, limited liability is not that give effect to legal personality do the equivalent of legal personality. Oth - be no universal agreement on what it not adopt that view. In those countries, er countries appear to equate limited means. Apparently the difficulty of there is no meaningful distinction liability with legal personality. defining it has been with us a long between an entity that has legal per - It might be supposed that an entity time; in 1928 Smith wrote that philoso - sonality and one that has legal per - that affords limited liability to all of its phers “have sought for the ‘internal sonality separate from its owners. members would generally possess legal nature’ of legal personality, for an Individual human beings have legal personality, and so it appears under abstract essence of some sort which personality in the sense that they can the laws of most countries that employ legal personality requires.