A “U.S. shareholder” of a controlled foreign corporation (CFC) is required to include in its gross income its pro rata share of a CFC’s “subpart F” income, regardless of whether such income is distributed. In general, a CFC is a foreign corporation that is more than 50 percent owned (directly, indirectly or constructively) by “U.S. shareholders.” Subpart F income includes most forms of passive income (e.g., interest, dividends, royalties, capital gains, etc.), as well as income from related party sales and service transactions that have little, if any, connection with the CFC’s country of incorporation.
Under Sections 951(b), 957(c) and 7701(a)(4) of the Internal Revenue Code (the “Code”), a U.S. partnership (including a U.S. LLC taxed as a partnership) is treated as a “U.S. shareholder” for subpart F purposes, even if all of its partners are foreign persons that are not subject to U.S. federal income tax. The IRS has never challenged this position. In fact, the IRS has indicated on more than one occasion that no consideration has ever been given to requiring a foreign person to include in its income any portion of the subpart F income passing through a U.S. partnership. See 1995 FSA Lexis 496 (March 17, 1995) and 1995 FSA Lexis 131 (March 17, 1995).
Therefore, the receipt of passive income (e.g., interest) by a foreign corporation that is more than 50 percent owned by a U.S. partnership, will give rise to subpart F income that is includible in the gross income of a U.S. shareholder of a CFC (i.e., the U.S. partnership), even though no U.S. person actually will be subject to U.S. federal income tax on that income. While the IRS has challenged the affirmative use of U.S. partnerships in the outbound context when the foreign partners themselves are CFCs with U.S. shareholders that are subject to U.S. federal income tax (see IRS Notices 2010-41 and 2009-7), the IRS has never challenged the use of a U.S. partnership for the sole purpose of creating a CFC in the inbound context.
This disparity in treatment may lead to a number of interesting tax planning opportunities when structuring inbound investments into the United States.
Section 163(j) Interest Stripping Rules
For example, if a U.S. corporation’s debt-to-equity ratio exceeds 1.5 to 1, Section 163(j) limits a U.S. corporation’s interest deductions to 50 percent of its taxable income where, (i) the interest is paid to a related foreign person and (ii) no (or reduced) U.S. withholding tax is imposed on such payment. Under Proposed Regulation Section 1.163(j)-4, however, a payment of interest that is exempt from U.S. withholding tax (for example, either under the portfolio interest exception or pursuant to an income tax treaty) is deemed to be subject to tax, and therefore not subject to Section 163(j), to the extent the interest results in an inclusion in the gross income of a U.S. shareholder of a CFC for subpart F purposes.
As noted above, a U.S. partnership is treated as a U.S. shareholder under the subpart F rules, even if all of its partners are foreign persons. Therefore, interest paid by a U.S. corporation to a foreign corporation that is owned by a U.S. partnership that has exclusively foreign partners, all of which are exempt from U.S. federal income tax, will not be subject to Section 163(j).
This opportunity may be useful in hedge fund or private equity fund structures that have a foreign feeder and use a U.S. corporation as a blocker corporation. Instead of the foreign investors investing through an entity taxed as a foreign partnership, the foreign investors could invest in an entity taxed as a U.S. partnership and potentially avoid the limitations imposed by Section 163(j).
Section 267(a)(3) Accruals to Related Foreign Persons
Section 267(a)(3) prevents a U.S. corporation from currently deducting an amount accrued to a related foreign person until the amount actually is paid. An exception is provided, however, that allows a corporation to deduct the amount accrued in a taxable year prior to the year of payment where the amount accrued is includible in the gross income of a U.S. person who owns stock in a CFC.
Therefore, similar to the opportunity mentioned above, a U.S. corporation potentially can deduct an amount accrued to a related foreign person in a taxable year prior to payment, where the related foreign person is a CFC solely because it is owned by a U.S. partnership that has exclusively foreign partners that are not subject to U.S. federal income tax.
Converting Foreign Source ECI into Subpart F Income
While foreign corporations are generally not subject to U.S. federal income tax, they are subject to tax like a U.S. corporation on any income effectively connected to a U.S. trade or business (otherwise known as ECI). Although this rule typically applies only to U.S.-source ECI, there are certain categories of foreign-source income that can be treated as ECI under Section 864(c)(4)(B).
If, however, the foreign corporation is a CFC and the foreign-source ECI also gives rise to subpart F income (which it likely would), the subpart F rules will trump the ECI rules, regardless of whether any amount is taxable in the hands of a U.S. person. Regulation Section 1.864-5(d)(2), example 1. Accordingly, it may be possible for a foreign corporation that is owned by foreign persons and that is subject to U.S. federal income tax on foreign-source ECI to interpose a U.S. partnership in between the corporation and its foreign shareholders to take advantage of the CFC trumping rule, without actually triggering any U.S. federal income tax.
Avoiding Taxable Dividend
Under Section 332(d), a liquidating distribution to a foreign corporation of an “applicable holding company” is treated as a dividend (rather than non-taxable income) that generally will be subject to a 30 percent U.S. withholding tax. In general, an applicable holding company is a domestic corporation that (i) has been in existence for less than 5 years and (ii) substantially all of its assets consist of stock in other members of an affiliated group. An exception exists, however, if the foreign corporation is a CFC. In this situation, the liquidating distribution generally will be exempt from U.S. withholding tax. Therefore, it may be possible to convert taxable dividend income into a non-taxable distribution by interposing a U.S. partnership in between the foreign corporation and its shareholders to cause such foreign corporation to be characterized as a CFC.
Can the IRS Challenge These Structures?
If the IRS were to challenge the use of U.S. partnerships in these situations, it would seem that the most likely scenario would be an attack under the partnership anti-abuse rules. It is interesting to note, however, that in Notice 2010-41 decided against the use of these provisions, but instead selectively chose to treat the U.S. partnership as a foreign partnership to prevent the purported abuse. This may be because the partnership anti-abuse rules themselves contain an example that approves the interposition of a U.S. partnership in between the shareholders and a foreign corporation for the sole purpose of converting the foreign corporation into a CFC, which would allow the shareholders to take advantage of more favorable foreign tax credit provisions. Regulation Section 1.701-2(f), example 3.
Other possible avenues of attack include the use of judicial doctrines, such as substance over form, sham transaction and economic substance. However, those arguments typically are much more difficult to sustain.