The Corporate Transparency Act: FinCEN Clarifies the Subsidiary Rule Exemption

The Corporate Transparency Act (CTA) entered into force on Jan. 1, 2024. Under the beneficial ownership information reporting rule of the CTA, certain entities – such as corporations, limited liability companies and other similar entities – are required to report identifying information about themselves and their beneficial owners (i.e., the individuals who directly or indirectly own or control a company). Reporting entities formed on or after Jan. 1, 2024, must report their company applicants.

Of the 23 reporting exemptions, one of the most important is for subsidiaries of certain exempt entities (Subsidiary Exemption). This exemption applies to an entity "whose ownership interests are controlled or wholly owned, directly or indirectly, by one or more entities …" of the types that are exempt from reporting, other than a money transmitting or money services business, a pooled investment vehicle, an entity assisting a tax-exempt entity or an inactive entity (exempt entity).¹ Since the promulgation of the final regulations on Beneficial Ownership Information Reporting Requirements on Sept. 30, 2022 (BOIR Final Rule), there has been ongoing uncertainty as to how the "control prong" of the Subsidiary Exemption works, particularly if an exempt entity controlled some but not all of the ownership interests of the subsidiary.

Subsidiary Exemption FAQ

On Jan. 12, 2024, the Financial Crimes Enforcement Network (FinCEN) issued a response to the frequently asked question (FAQ): Does a subsidiary whose ownership interests are partially controlled by an exempt entity qualify for the subsidiary exception?²

The response was as follows:

No. If an exempt entity controls some but not all of the ownership interests of the subsidiary, the subsidiary does not qualify. To qualify, a subsidiary's ownership interests must be fully, 100 percent owned or controlled by an exempt entity.

A subsidiary whose ownership interests are controlled or wholly owned, directly or indirectly, by certain exempt entities is exempt from the BOI reporting requirements. In this context, control of ownership interests means that the exempt entity entirely controls all of the ownership interests in the reporting company, in the same way that an exempt entity must wholly own all of a subsidiary's ownership interests for the exemption to apply.

The FAQ removes the uncertainty as to the how one should interpret the "control" prong of the Subsidiary Exemption and, in passing, the ownership prong of the Subsidiary Exemption: One or more exempt entities must wholly own all of the ownership interests of a subsidiary or wholly control all of the ownership interests of a subsidiary for the Subsidiary Exemption to apply.

Background to the Subsidiary Exemption: Statute and Regulations

The Subsidiary Exemption in the statute reads in substance as follows:³

Any corporations, limited liability company or other similar entity of which the ownership interests are owned or controlled, directly or indirectly, by 1 or more [exempt entities].

The Subsidiary Exemption in the Proposed Regulations reads in substance as follows:⁴

Any entity of which the ownership interests of such entity are controlled or wholly owned, directly or indirectly, by one or more [exempt entities].

Importantly, in the Proposed Regulations, FinCEN interprets the definite article "the" underlined in the quoted statutory text above as requiring an entity to be owned entirely by one or more exempt entities in order to qualify for its own reporting exemption.⁵

The Subsidiary Exemption in the Final Rule reads in substance as follows:⁶

Any entity whose ownership interests are controlled or wholly owned, directly or indirectly, by one or more exempt entities.

FinCEN, in the Preamble to the Final Rule of the Subsidiary Exemption, wrote:⁷

Commenters expressed concern about the scope of this exemption. Many commenters urged FinCEN to clarify that the exemption would apply only to "wholly controlled or wholly owned" subsidiaries (versus the proposed rule that reads "controlled or wholly owned") in order to make the exception as narrow as possible and avoid creating a loophole to evade reporting requirements.⁸

FinCEN is adopting [the Subsidiary Exemption] as proposed, with a minor grammatical edit. While hewing to the statutory language, the interpretation prevents entities that are only partially owned by exempt entities from shielding all of their ultimate beneficial owners—including those that beneficially own the entity through a non-exempt parent—from disclosure. FinCEN does not need to add "wholly" before "controlled" because FinCEN assesses that the latter covers the intended concept of control set out in the CTA. FinCEN also determined that extending the exemption to majority-owned subsidiaries would include entities unintended by the language of the CTA. [footnotes omitted].

Analysis

Though the operating rule of the Subsidiary Exemption FAQ is clear, practitioners seeking to apply the exemption nonetheless must carefully identify, review and analyze the structure to determine whether the Subsidiary Exemption may apply. That may not be as simple as it seems.

First, the exemption applies to the entire ownership or control of "ownership interests." The term "ownership interests" is key in determining whether an individual is a beneficial owner under the 25 percent ownership test.⁹ Thus, although not explicitly defined or cross-referenced in the Subsidiary Exemption, the definition of an "ownership interest" and the concept of "ownership or control of an ownership interest" are integral to determining applicability of the Subsidiary Exemption.

Second, the concepts of ownership of an ownership interest and control of an ownership interest are discrete concepts and disjunctive tests for purposes of applying the Subsidiary Exemption. Pursuant to the Subsidiary Exemption FAQ, either 100 percent ownership of the ownership interests in a subsidiary or 100 percent control of the ownership interests of a subsidiary enable the application of the Subsidiary Exemption. That complete ownership or control can be by one or more exempt entities. This interpretation raises the possibility that a first-tier entity of which an exempt entity has complete voting control, but not complete ownership, would not be exempt, but a second-tier entity owned 100 percent by that first-tier entity could qualify for the Subsidiary Exemption because all of its ownership interests are indirectly controlled by the exempt entity with voting control of the first-tier entity.

Third, the ownership or control must constitute the entirety of the ownership interests in the subsidiary. That may be difficult to assess in certain circumstances because of the expansiveness of the term "ownership interests" set forth in the Final Rule.

Fourth, because of the expansive interpretation of the "ownership and control" concept contained in the Final Rule, assessing whether the exemptive test is applicable may prove troublesome. That interpretation is summarized below:

The terms "ownership" and "control" include direct or indirect ownership or control of an ownership interest of a reporting company through any contract, arrangement, understanding, relationship or otherwise, such as through 1) joint ownership, 2) another individual acting as a nominee, intermediary, custodian or agent on behalf of such individual, 3) a trust or similar arrangements that holds such ownership interest as a trustee (or other individual) with the authority to dispose of trust assets, as a beneficiary who is the sole permissible recipient of income and principal from the trust or has the right to demand a distribution of, or withdraw substantially all of the trust assets, or a grantor of the trust who has the power to revoke the trust or withdraw assets from the trust, or 4) ownership or control of one or more intermediate entities or its ownership interests that own or control the ownership interests of the reporting company. In each of the above situations, it is possible for multiple parties to have overlapping "control" of ownership interests, and the FAQ does not elucidate the consequences of an exempt entity with control of ownership interests that overlaps with control by nonexempt persons, for example through a trust with an exempt "bank" as trustee but with co-trustees or other parties deemed to have ownership or control who are not exempt.

To further complicate matters, the concept of "control" for purposes of the application of the Subsidiary Exemption cannot be equated with the term "substantial control," a test that is used for purposes of identifying beneficial owners, because the substantial control test relates to both a different and a broader category of control. Moreover, the term "control" cannot be definitively gleaned from other federal law or regulations.¹⁰

Can One Rely on FAQs?

FinCEN prepared FAQs in response to inquiries received relating to the Final Rule, but the FAQs are explanatory only and do not supplement or modify any obligations imposed by statute or regulation.¹¹

Takeaways

• The Subsidiary Exemption FAQ is a helpful explanation of how to comply with the Subsidiary Exemption, which can have broad application in exempting entities from beneficial ownership information reporting.
• In applying the Subsidiary Exemption, the determination applies exclusively to the ownership or control of an "ownership interest" in a subsidiary. These tests are in alternative and apply only by reference to ownership interests.
• The Subsidiary Exemption is applicable only in cases where the ownership interests of a subsidiary are fully owned or fully controlled by one or more exempt entities, either directly or indirectly.
• The Subsidiary Exemption FAQ clarifies that the Subsidiary Exemption does not apply to subsidiaries in cases where the ownership interests are either partially owned or partially controlled by exempt entities, as that would not, in FinCEN's view, be consistent with the underlaying policy of the CTA.

Notes

¹ 31 CFR 1010.380(c)(2)(xxii).

² Beneficial Ownership Information Reporting, Frequently Asked Questions, L. 6, Issued Jan. 12, 2024.

³ 31 U.S.C. 5336(a)(11)(b)(xxii) (Beneficial Ownership Information Reporting Requirements).

⁴ Proposed 31 CFR 1010.380(c)(2)(xxii).

⁵ Preamble, Proposed Regulations, at 69,940.

⁶ Final Rule, 31 CFR 1010.380(c)(2)(xxii).

⁷ Preamble, Final Rule at 59,543.

⁸ Preamble, Final Rule at 59,543.

⁹ 31 CFR § 1010.380(d) defines Beneficial Owner. 31 C.F.R .1010.380(d)(2)(i) defines the term "ownership interest). 31 CFR 1010.380(d)(2)(ii) defines the concept of "ownership or control of ownership interest."

¹⁰ The Preamble to the Final Rule is explicit in stating that definitions of "control" found elsewhere in the United States Code and Code of Federal Regulations, while informative, is not dispositive for purposes of the beneficial ownership information reporting provisions. Preamble, Final Rule at 59,528.

¹¹ Supra, Note 2.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.