Seth J. Entin (Holland & Knight, Miami), The Foreign Reverse Hybrid and the Estate Tax, 101 Tax Notes Int'l 1255 (Mar. 8, 2021):
In this article, the author demonstrates that the estate of a foreign individual who dies owning an interest in a foreign reverse hybrid entity is not subject to U.S. federal estate tax in connection with an interest in the entity, even if the entity owns U.S.-situs assets.
It is not uncommon for foreign individuals to invest into the United States through entities that are formed as partnerships under foreign law. For example, foreign individuals may make private investments through entities that are established as Canadian, U.K., or Cayman Islands limited partnerships. Or the sponsors of funds may establish entities of this nature as vehicles into which their foreign investors (and sometimes others) will invest.
There are several reasons for forming the entity as a partnership under the laws of a foreign country. For example, the partnership form may allow for a more flexible type of governance and allocation of income, and it may allow beneficial tax treatment in the country where the partnership is established or in the country of one or more of the partners. Further, the use of a partnership entity may allow for treaty benefits if the partners are tax residents of a country that is a party to an income tax treaty with the United States, even if the partnership is not a tax resident of a treaty country.
Although the entity is formed as a partnership under foreign law, in many cases it will make a check-the-box election on Form 8832, “Entity Classification Election,” to be classified as a foreign corporation for U.S. federal tax purposes. This type of entity is often referred to as a foreign reverse hybrid entity because it is a partnership for foreign law purposes but has elected to be classified as a corporation for U.S. federal tax purposes.
The entity will typically make a check-the-box election to be classified as a foreign corporation for U.S. federal tax purposes to (among other things) (1) alleviate the need for the foreign partners to file federal income tax returns if the entity realizes income that is effectively connected with a trade or business in the United States; and (2) protect the foreign partners’ estates from the U.S. federal estate tax if the entity owns U.S.-situs assets. Even though the entity has elected to be classified as a foreign corporation for U.S. federal tax purposes, and even if the entity is not a tax resident of a treaty country, treaty benefits may be available if the entity is treated as transparent for purposes of the tax laws of the country of the partners’ residence.
Regarding this second reason, it is well established that a foreign individual’s estate is not subject to U.S. federal estate tax in connection with an interest in a foreign corporation, even if the corporation owns U.S.-situs assets. It is my understanding, however, that some practitioners have raised questions about whether a foreign reverse hybrid entity is respected as a foreign corporation for U.S. federal transfer tax purposes — that is, for U.S. federal estate, gift, and generation-skipping transfer tax purposes. Those questions are based on the practitioners’ reading of a 2009 Tax Court case, Pierre, which they interpret to say that the check-the-box regime does not apply for U.S. federal transfer tax purposes. If the check-the-box election is not respected for transfer tax purposes, the foreign individual’s estate may be subject to U.S. federal estate tax if the individual dies while the foreign reverse hybrid entity owns U.S.-situs assets. Apparently, some practitioners have even taken this a step further and posited that because, in their view, the check-the-box regime does not govern for U.S. federal transfer tax purposes, an entity established as a corporation under foreign law that has checked the box to be a disregarded entity (a forward hybrid entity) still provides estate tax protection to a foreign individual.