IRS RECONSIDERS RULING ON CLASSIFICATION OF GERMAN BUSINESS ENTITY.

Rev. Rul. 93-4

ISSUE

How is the German Gesellschaft mit beschrankter Haftung (GmbH) considered in Rev. Rul. 77-214, 1977-1 C.B. 408, classified for federal tax purposes under section 301.7701-2 of the Procedure and Administration Regulations?

FACTS

This revenue ruling reconsiders Rev. Rul. 77-214. In Rev. Rul. 77-214, a GmbH, a German business entity, was classified as an association for federal tax purposes.

A GmbH is a juridical person, formed pursuant to a memorandum of association, and which under applicable German law has the corporate characteristics of limited liability and centralization of management. In Germany the memorandum of association is a contract between two or more persons, who may be individuals or legal entities, citizens or aliens, or residents or nonresidents. After completion of the memorandum of association, the organizers of a GmbH must file for registration with the Commercial Register for the jurisdiction in which it is located. When the organizers have complied with all the statutory requirements, the judge in charge of the Commercial Register orders the registration of the company, which as of that date acquires legal status. Absent a provision to the contrary in the memorandum of association, the transfer of an interest in a GmbH does not cause it to dissolve.

In Rev. Rul. 77-214, the GmbH was formed by two wholly owned United States domestic subsidiaries of a United States corporation. One subsidiary owns 90 percent of the quotas (shares) of the GmbH, while the other subsidiary owns the remaining 10 percent of the quotas. The two subsidiaries were expressly formed by the parent to provide marketing and support services for the parent's operation in foreign countries. The GmbH in turn was formed by the subsidiaries to facilitate the provision of these services in Germany.

The GmbH's memorandum of association provides that the GmbH shall be dissolved by the death, insanity, or bankruptcy of any of the quotaholders. The memorandum of association also provides that the quotas of the GmbH are not freely transferable, and the sale, pledging, or disposal of the quotas or parts thereof requires the prior written approval of all quotaholders.

LAW AND ANALYSIS

Section 301.7701-1(b) of the regulations states that the Internal Revenue Code prescribes certain categories or classes into which various organizations fall for purposes of taxation. These categories or classes include associations (which are taxable as corporations), partnerships, and trusts. The tests or standards that are to be applied in determining the classification of an organization are set forth in sections 301.7701-2 through 301.7701-4.

Section 301.7701-2(a)(1) of the regulations sets forth the following basic characteristics of a corporation: (1) associates; (2) an objective to carry on business and divide the gains therefrom; (3) continuity of life; (4) centralization of management; (5) limited liability; and (6) free transferability of interests. Whether a particular organization is to be classified as an association must be determined by taking into account the presence or absence of each of these corporate characteristics.

Section 301.7701-2(a)(2) of the regulations provides that the characteristics common to partnerships and corporations are not material in attempting to distinguish between an association and a partnership. Since associates and an objective to carry on business and divide the gains therefrom are generally common to corporations and partnerships, the determination of whether to treat for tax purposes an organization having those characteristics as a partnership or as an association depends on whether there exists continuity of life, centralization of management, limited liability, and free transferability of interests. Section 301.7701-2(a)(3) provides that an unincorporated organization will not be classified as an association unless the organization has more corporate characteristics than noncorporate characteristics.

Rev. Rul. 73-254, 1973-1 C.B. 613, holds that the classification of a foreign unincorporated business organization for federal tax purposes will be determined under section 7701 of the Internal Revenue Code and the regulations thereunder. However, the local law of the foreign jurisdiction must be applied in determining the legal relationships of the members of the organization among themselves and with the public at large, as well as the interests of the members of the organization in its assets.

Rev. Rul. 75-19, 1975-1 C.B. 382, holds that a partnership of four domestic subsidiary corporations of the same corporate parent, formed under a statute corresponding to the Uniform Partnership Act, lacks the corporate characteristics of continuity of life, centralization of management, and limited liability.

Rev. Rul. 88-8, 1988-1 C.B. 403, provides that all foreign entities are to be considered "unincorporated organizations," for purposes of section 301.7701-2(a)(3) of the regulations. The revenue ruling holds that when classifying a foreign entity the applicable foreign statute and the entity's organization agreements must be examined to determine whether the entity is classified as a corporation for federal tax purposes. The revenue ruling further holds that the standards set forth in section 301.7701-2 must be applied. Thus, the same standards apply for the classification of foreign entities and unincorporated domestic entities.

Under German law, the GmbH possesses the characteristics of associates and an objective to carry on business and divide the gains therefrom, which characteristics are common to both corporations and partnerships. The GmbH also has, under German law, the corporate characteristics of limited liability and centralization of management. Thus, the GmbH will be classified as an association if it possesses either of the two remaining corporate characteristics enumerated in the regulations, continuity of life or free transferability of interests.

German law contains numerous optional provisions that can be modified by a GmbH's memorandum of association so that, in effect, depending on the construction of the memorandum of association, the GmbH can assume the characteristics of a corporation or of a partnership.

Accordingly, a GmbH is not automatically classified as either a partnership or an association taxable as a corporation for federal tax purposes. The classification of a GmbH as a partnership or an association depends on all the relevant facts and circumstances of each case, including the memorandum of association filed with the judge of the Commercial Register having jurisdiction of that register and the German law interpretation of the memorandum of association.

Rev. Rul. 77-214 provides that a dissolution event has significance in establishing the corporate characteristic of continuity of life only if there exist separate interests that could compel a dissolution. It subsequently has been determined that the presence or absence of separate interests is not relevant to the determination of whether an entity possesses continuity of life. Because the memorandum of association of the GmbH requires dissolution upon the bankruptcy of either quotaholder, without further action, the GmbH lacks continuity of life.

Under the memorandum of association consent must be obtained to transfer an interest. However, because two wholly owned domestic subsidiaries own 100 percent of the quotas of the GmbH, the controlling parent can make all the transfer decisions for its wholly owned subsidiaries. Therefore, Rev. Rul. 77-214 concludes that the GmbH possesses the corporate characteristic of free transferability of interests. To lack free transferability, the possibility of an impediment to transfer must exist. Because all the members of the GmbH are commonly controlled, consent to transfer is not meaningful, and Rev. Rul. 77-214's conclusion on free transferability of interests is reaffirmed.

Under German law, the memorandum of association of a GmbH can prohibit the transfer of an interest and a transfer in violation of this prohibition is not effective. In addition, the memorandum of association of a GmbH can provide for the dissolution of the GmbH upon the transfer of an interest and that provision is effective under German law. If the memorandum of association of the GmbH in Rev. Rul. 77-214 had either prohibited the transfer of an interest or provided for the dissolution of the GmbH upon the transfer of an interest, the GmbH would have lacked free transferability of interests.

HOLDING

The GmbH described above possesses three of the four corporate characteristics that distinguish an association taxable as a corporation from a partnership and it is classified as an association for federal tax purposes.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 77-214, 1977-1 C.B. 408, is modified and superseded effective /*/. Organizations existing prior to /*/, that reasonably relied upon Rev. Rul. 77-214 can maintain their current classification by reporting consistently with that classification on the first relevant federal income tax return of the organization or member filed after /*/.

DRAFTING INFORMATION

The principal author of this revenue ruling is Ronald M. Gootzeit of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Ronald M. Gootzeit on (202) 622-3080 (not a toll-free call).

/*/ Insert date 30 days after date of this Internal Revenue Bulletin.