With all of the recent negative publicity focused on the outbound restructuring of U.S. multinationals engaging in so-called “inversion” transactions (see prior blog “Corporate Inversions Showing No Signs of Slowing Down”), little, if any attention, has focused on the potential tax planning opportunities available in the inbound area resulting from the (likely unintended) consequences of Section 7874. A typical inversion involves a transaction or series of transactions through which a U.S.-based multinational restructures its corporate group, so that the ultimate parent corporation of the group becomes a foreign entity. This is typically accompanied by the transfer of the U.S. multinational’s ownership of its foreign subsidiaries to the new foreign parent, and an increase in the leveraging of the U.S. operations through intercompany debt.
If the original shareholders of the U.S. parent own at least 80 percent of the shares of the inverted foreign corporation after the transaction, and no substantial business activities occur in the foreign country where the new foreign parent is incorporated, Section 7874(b) treats the foreign parent as a U.S. corporation for all purposes of the Internal Revenue Code (the “Code”). It is important to note that Section 7874 (at least according to the plain language of the statute) is not limited to situations where the shareholders of the U.S. parent are U.S. shareholders. Therefore, as illustrated below, Section 7874 appears to have relevance in a number of everyday inbound transactions and could lead to some interesting tax planning opportunities.
Avoidance of U.S. Withholding Tax on Dividends
Generally, a U.S.-source dividend paid to a foreign person will be subject to a 30% U.S. withholding tax, unless reduced or eliminated by an applicable income tax treaty. To qualify for treaty benefits, however, a treaty’s limitation on benefits provision, if any, must be satisfied. Accordingly, not all foreign persons are eligible for U.S. income tax treaty benefits, especially if those foreign persons are resident in a jurisdiction that does not have a comprehensive income tax treaty with the United States.
For example, a dividend paid by a U.S. corporation to its 100 percent foreign shareholder who is resident in Dubai generally would be subject to a 30% U.S. withholding tax because no income tax treaty currently exists between the United States and the UAE. If, however, the foreign shareholder transfers all of its shares in the U.S. operating company to a newly-formed corporation organized in the Cayman Islands, it appears that no U.S. withholding tax would be imposed when a dividend is paid from the U.S. to the Cayman holding company. This is a result of Section 7874(b) treating the Cayman holding company as a U.S. corporation because (i) the foreign shareholder would own at least 80 percent of the shares of the new foreign parent and (ii) no substantial business activities would occur in the Cayman Islands. Accordingly, this restructuring appears to completely eliminate U.S. withholding tax on the dividend paid to the Cayman corporation, despite the fact that no income tax treaty exists between the United States and the Cayman Islands (or the UAE).
Of course, it should be noted that because Section 7874 treats the Cayman holding company as a U.S. corporation for all purposes of the Code, the dividend is treated as being paid from one U.S. corporation to another U.S. corporation. If structured correctly, however, the receipt of the dividend by the Cayman/U.S. holding company should be eligible for the 100 percent dividend received deduction. Further it also may be possible for the Cayman/U.S. company to repatriate cash to its shareholder resident in Dubai without triggering a U.S. withholding tax (which, by the way, would need to be collected by a Cayman holding company with a foreign shareholder). This may be accomplished by having the Cayman/U.S. holding company distribute a note to the shareholder in Dubai in a taxable year prior to its receipt of a dividend from the U.S. operating company. Future payments on the note would be treated as tax free payments of principal. It is also possible U.S. withholding tax on the dividend could be substantially reduced if the Cayman/U.S. holding company is characterized as “an existing 80/20 company.” It is certainly questionable whether Section 7874 was intended to apply in these circumstances, but the plain language of the statute clearly supports such a result.
Avoidance of FIRPTA
In addition to the avoidance of U.S. withholding tax on dividends, Section 7874 may also potentially help in avoiding the Foreign Investment in U.S. Real Property Tax Act (“FIRPTA”). In general, Section 897 taxes a foreign person on any gain recognized on the disposition of a U.S. real property interest. In addition, Section 1445 requires the purchaser to withhold 10 percent of the purchase price from the sales proceeds due to the foreign seller of the U.S. real property interest, even if such amount is greater than the actual tax due. For example, a foreign person who sells a U.S. real property interest for $10 million will be subject to $1 million withholding tax, even if the actual gain is only $50,000 (and the actual tax liability is only $10,000) because the asset has a cost basis of $9,950,000.
Section 7874 could potentially help avoid these results. For example, assume a foreign person owns U.S. real property through a U.S. corporation. A sale by that foreign person of the shares of the U.S. corporation would be subject to the FIRPTA consequences discussed above. If, however, the foreign person transfers his shares of the U.S. corporation to a foreign holding company organized in the BVI, Section 7874 would treat the BVI corporation as a U.S. corporation.
Accordingly, the BVI/U.S. holding company could now sell the shares of the U.S. real property holding corporation without being subject to the FIRPTA withholding tax rules. While the BVI/U.S. holding company will be subject to U.S. corporate income tax on any gain recognized on the sale, the IRS would have a much more difficult time collecting the tax due. This is because without the 10 percent FIRPTA withholding, the proceeds from the sale of the shares likely will be held in a foreign bank account owned by a foreign corporation with foreign shareholders. Good luck!
Again, it is unlikely these results ever were intended when Section 7874 was enacted. Nevertheless, the plain language of the statute clearly supports this interpretation.
Potentially Adverse Consequences To Foreign Persons Under Section 7874
While Section 7874 may be advantageous to foreign persons in the circumstances described above, there are a few potentially adverse tax situations that could arise as a result of Section 7874 applying in the inbound context. For example, practically all U.S. income tax treaties provide that unless a foreign corporation has a permanent establishment in the United States such foreign corporation will not be subject to direct U.S. federal income tax. If, however, Section 7874 treats a foreign a corporation as a U.S. corporation for all purposes, these income tax treaties essentially will be overridden by Section 7874 because a foreign corporation resident in a treaty jurisdiction now will be subject to U.S. federal income tax on its worldwide income, regardless of whether such corporation has a permanent establishment in the United States.
Furthermore, a foreign person attempting to avoid U.S. estate tax by transferring the shares of a U.S. corporation to a foreign holding company will now find that he or she owns a U.S.-situs asset for estate tax purposes as a result of Section 7874. It is certainly hard to believe that these were the types of transactions Congress was targeting when Section 7874 was enacted. Nevertheless, Section 7874 as presently drafted, and without any further guidance, would seem to apply in the situations described above.