It’s Complicated
The Code includes a number of complex rules that are aimed at those overseas business and investment activities of U.S. taxpayers that Congress has determined may result in the improper deferral or avoidance of U.S. income tax.
Because these business or investment transactions may involve convoluted capital or organizational structures – including some that lack a bona fide business purpose – Congress is often challenged with crafting legislation to ensure that U.S. taxpayers participating in such transactions will remit to the IRS the amount of income tax that is properly owing in respect of these foreign activities, while at the same time being careful not to dissuade or disincentivize the same U.S. persons from pursuing what may turn out to be profitable ventures overseas.
There have been times, however, where Congresses has inadvertently either missed its intended target or taken an overbroad approach to a specific issue.
A recent example involves the 2017 amendment of the constructive ownership – specifically, downward attribution – rules found in the antideferral provisions of Subpart F of the Code.[i] Although several observers have written about this obvious drafting error and its concededly unintended consequences, Congress has been unable to redress the problem because of the ongoing dysfunctionality within that branch of government, while the IRS has inexplicably – at least from my perspective – refused to step into the breach.
Until this year, I have been fortunate not to have encountered a client who, because of this legislative drafting error – and oblivious to its existence – unexpectedly found themselves subject to the anti-deferral rules of Subpart F of the Code.
Before describing the 2017 amendment, a cursory review of Subpart F may be helpful.
Foreign Source Income of U.S. Persons
In general, the U.S. taxes its citizens and residents – including natural persons and legal entities – on both their U.S. and foreign-sourced income.[ii] For example, the foreign-sourced income attributable to the foreign branch[iii] of a domestic business is subject to U.S. income tax on a current basis; the same is true for a U.S. person’s share of foreign-sourced income realized by a domestic or foreign partnership of which the U.S. person is a member.[iv]
Foreign Corporations
However, if the foreign-sourced income is realized by a foreign corporation in which U.S. persons own not more than 50 percent of the equity, such U.S. persons will not be subject to U.S. income tax with respect to their “share” of the corporation’s foreign-sourced income until such income is distributed to them by the foreign corporation as a dividend.
That said, the U.S. takes a different approach when the foreign corporation is controlled by a small number of U.S. persons, presumably because such a small number should be able to agree on whether or not to compel a distribution by the foreign corporation.[v]
In that case, the U.S. has enacted anti-deferral rules that require certain U.S. persons to include in their gross income, for purposes of determining their U.S. income tax liability, their share of foreign-sourced income that is realized by a foreign corporation of which they are a shareholder.
CFCs – In General
The main U.S. anti-tax-deferral regime for foreign source income realized “indirectly” by U.S. persons is found in Subpart F of the Code,[vi] which addresses the taxation of such income that is realized by a so-called controlled foreign corporation (“CFC”).
A CFC is defined as any foreign corporation in which five or fewer U.S. persons[vii] own (directly, indirectly),[viii] or are considered as owning (constructively, through the application of certain attribution rules),[ix] more than 50-percent of the foreign corporation’s stock (measured by vote or value).[x] Only those U.S. persons who own at least 10-percent of the foreign corporation’s stock (measured by vote or value; each a “U.S. shareholder”) are considered in determining whether the “more than 50-percent” test is satisfied.[xi]
Those U.S. persons who are treated as U.S. shareholders of a CFC may be taxed currently on specified categories of income realized by the CFC,[xii] regardless of whether or not the CFC’s income has been distributed to these shareholders as a dividend.[xiii]
Attribution
According to the above-referenced attribution rules, if at least 10 percent but not more than 50 percent of the stock in a corporation is owned, directly or indirectly, by or for any person,[xiv] such person shall be considered as owning a proportionate share of the stock of a subsidiary owned, directly or indirectly, by or for such corporation (upward attribution).
If more than 50 percent of a subsidiary corporation’s stock is owned by another corporation, such other corporation is considered as owning all the stock of the subsidiary corporation for purposes of attributing such stock to the other corporation’s shareholders.[xv]
If 50 percent or more of the stock in a corporation is owned, directly or indirectly, by or for any person,[xvi] such corporation shall be considered as owning all of the stock of any other corporation owned, directly or indirectly, by or for such person (downward attribution).[xvii]
Downward Attribution
Prior to the Tax Cuts and Jobs Act,[xviii] stock owned by a foreign person, including a foreign corporation, was not attributed to a U.S. person, including a U.S. corporation – regardless of the size of the foreign person’s ownership interest in the U.S. person – for purposes of determining the status of a foreign corporation as a controlled foreign corporation and the status of a U.S. person as a U.S. shareholder.[xix]
Specifically, the Code[xx] provided that such downward attribution did not apply to treat a U.S. person as owning the stock of a foreign corporation owned by a foreign person. As a result, a wholly owned U.S. subsidiary of a foreign parent corporation was not treated as owning stock in other foreign corporations owned by its foreign parent (those in a brother-sister relationship to the U.S. subsidiary).[xxi]
This limitation on the application of downward attribution afforded certain taxpayers an opportunity to remove themselves from the reach of the CFC rules. In a common example, a new foreign parent corporation or another non-CFC affiliate could transfer property to a CFC in exchange for stock representing at least 50 percent of the voting power and value of the CFC. Such a transaction would ‘‘de-control’’ the CFC, thus converting the former CFC to a non-CFC, despite continuous ownership by U.S. shareholders, and avoiding the application of Subpart F.
TCJA
The TCJA[xxii] amended the above constructive ownership rules with the stated purpose[xxiii] of limiting the application of the downward attribution rule[xxiv] to situations in which the foreign-owned stock of a foreign corporation would only be attributed to a U.S. corporation that was “related” to the U.S. person whose status as a U.S. shareholder with respect to the foreign corporation was being determined.
As a result, stock of a foreign corporation owned by a foreign person would be attributed to a U.S. subsidiary corporation owned by such foreign person for purposes of determining whether the related U.S. person was a U.S. shareholder of the foreign corporation and whether the foreign corporation was a CFC.
In other words, the provision would require ‘‘downward attribution’’ from a foreign person to a U.S. person in circumstances in which prior law did not.[xxv]
Congress intended to render ineffective certain transactions among related persons that were used as a means of avoiding the Subpart F rules, including the ‘‘de-control’’ transactions described above.
All other instances of downward attribution of foreign stock owned by a foreign person to a U.S. subsidiary corporation – that was not related to the U.S. person whose status as a U.S. shareholder was being determined – would continue to be prohibited.
Inexplicably, however, and contrary to the intent of Congress, the TCJA[xxvi] amended the Subpart F attribution rules to allow all downward attribution, not just attribution between related persons.[xxvii]
Legislative History
The legislative intent to which I refer above is stated very clearly in the Congressional Committee reports issued prior to the enactment of the TCJA, in the Congressional Record before the Senate vote on the TCJA, and again in the Blue Book issued by the Joint Committee after the enactment.
Senate Finance Report. According to the Senate Report, the Committee did not intend ‘‘to cause a foreign corporation to be treated as a controlled foreign corporation with respect to a U.S. shareholder as a result of attribution of ownership under section 318(a)(3) [(downward attribution)] to a U.S. person that is not a related person (within the meaning of section 954(d)(3)) to such U.S. shareholder as a result of the repeal of section 958(b)(4)’’).[xxviii]
Conference Report. The House Conference Report that accompanied Bill H.R. 1 (the TCJA), followed the Senate Report, repeated that “the provision [(i.e., the repeal of IRC Sec. 958(b)(4))] is not intended to cause a foreign corporation to be treated as a controlled foreign corporation with respect to a U.S. shareholder as a result of attribution of ownership under section 318(a)(3) [(downward attribution)] to a U.S. person that is not a related person (within the meaning of section 954(d)(3) to such U.S. shareholder as a result of the repeal of section 958(b)(4).”[xxix]
Stated differently, Congress intended to retain the principles of IRC Sec. 958(b)(4) where the downward attribution of stock ownership would be to a U.S. person who is unrelated to the other U.S. shareholders of the foreign corporation.
Senate Floor Pre-Enactment. Only three days prior to the enactment of the TCJA, Senator Perdue (of Georgia) engaged in a colloquy with Senator Hatch (of Utah), the then chair of the Senate Finance Committee:[xxx]
Mr. PERDUE. “Mr. President, I rise today to engage in a colloquy with
my friend and colleague, the distinguished chairman of the Senate
Finance Committee, Senator Hatch.
“I would like to confirm my understanding of the modification of the
section 958(b) stock attribution rules contained in the Tax Cuts and
Jobs Act. The Senate Finance Committee explanation of this bill, as
released by the Senate Budget Committee, definitively states, ‘This
provision is not intended to cause a foreign corporation to be treated
as a controlled foreign corporation with respect to a U.S. shareholder
as a result of attribution of ownership under section 318(a)(3) to a
U.S. person that is not a related person (within the meaning of Section
954(d)(3)) to such U.S shareholder as a result of the repeal of
section 958(b)(4).’
“I would like to confirm that the conference report language did not
change or modify the intended scope this statement. As you know, I
filed an amendment to the Senate bill, Senate amendment No. 1666 would
have codified this explanatory text of the Finance Committee report.
“I also want to confirm that the Treasury Department and the Internal
Revenue Service should interpret the stock attribution rules consistent
with this explanation of the bill.”
Mr. HATCH. “The Senator is correct. The conference report language for
the bill does not change or modify the intended scope of the statement
he cites. The Treasury Department and the Internal Revenue Service
should interpret the stock attribution rules consistent with this
explanation, as released by the Senate Budget Committee. I would also
note that the reason his amendment No. 1666 was not adopted is because
it was not needed to reflect the intent of the Senate Finance Committee
or the conferees for the Tax Cuts and Jobs Act.
“I thank my friend from Georgia for his leadership on this issue to
ensure that the stock attribution rules operate consistent with our
intent and do not result in unintended consequences. I look forward to
continuing to work with him on this important issue.”
Mr. PERDUE. “I thank the chairman for the clarification and appreciate
his outstanding leadership and work on this important and historic
legislation.”
Joint Committee. Finally, the Blue Book prepared by the Joint Committee on Taxation and published approximately one year after the TCJA was signed into law, stated that a technical correction to the application of the downward attribution rule may be necessary to reflect the intent expressed by Congress as set forth in the above-referenced Committee Reports.
Consequences
A simple example should illustrate the impact of the overbroad repeal of the prohibition on downward attribution and why the Senate, Conference, and Joint Committee reports expressly stated that a foreign corporation is not to be treated as a CFC with respect to a U.S. shareholder by applying the downward attribution rule to a U.S. person that is not a related person to such U.S. shareholder.
Assume U.S. Individual owns a 10 percent interest in foreign Parent Corp; the other 90 percent is owned by a foreign person unrelated to Individual.
Assume also that Parent Corp owns 100 percent of two subsidiary corporations: foreign Sub One and domestic Sub Two, which are brother-sister corporations.
Individual has an indirect 10 percent interest in each of Sub One and Sub Two (through Parent Corp).
Parent Corp’s 100 percent direct interest in Sub One is attributed downward to Sub Two (the U.S. corporation).
Because Sub Two is treated as owning 100 percent of Sub One (a foreign corporation), the latter is treated as a CFC.
Thus, as a result of the downward attribution to Sub Two, above – an entity with respect to which Individual has only an indirect 10 percent interest, which is hardly enough to make them related persons – Individual is treated as a U.S. shareholder with respect to Sub One and must include its share of Sub One’s (i) Subpart F income and (ii) GILTI.[xxxi]
Clearly, Congress did not intend to require a U.S. person. such as Individual, to include Sub One’s foreign source income in Individual’s income for purposes of determining Individual’s U.S. income tax liability. After all, Individual is no position, either alone or with up to four other U.S. persons, to influence the distribution of Sub One’s earnings and profits.
Subsequent Developments
Following the mid-term elections of 2018, the then Administration’s Party lost control of the House of Representatives.
Lame-Duck
Still, the lame-duck Republican Congress tried to enact a technical correction in December 2018 that would have retroactively addressed the unintended consequences of repealing the prohibition on downward attribution.[xxxii]
It didn’t get off the ground.[xxxiii]
CARES Act
At one point, it appeared that the Coronavirus Aid, Relief, and Economic Security Act[xxxiv] was going to reinstate the pre-TCJA version of the anti-downward attribution rule so as to prevent CFC treatment for a foreign corporation with respect to a more-than-10 percent U.S. shareholder, but allow downward attribution in the case of a more-than-50% U.S. shareholder[xxxv] for the decontrolling transactions that motivated its repeal.[xxxvi]
It is unclear why this provision was not in the final bill.
In 2020, the then Administration lost the White House.
Build Back Better
In 2021, the Biden Administration proposed to amend the CFC attribution rules by adding a paragraph to prohibit the application of downward attribution “to consider a United States person as owning stock which is owned by a person who is not a United States person.”[xxxvii]
As we all know, this version of the Democrat-sponsored Build Back Better bill failed to be enacted for several reasons, but two in particular stand out: Senators Manchin and Sinema.
In August of 2022, a significantly pared back version of the original bill was enacted as the Inflation Reduction Act.[xxxviii]
Where Are We?
Good question.
It appears we are no closer today to correcting the above-described unintended consequences resulting from the repeal of the prohibition on downward attribution to a U.S. person than we were at any other time since the enactment of the TCJA.
Although the IRS has provided some relief from other unintended consequences of the repeal,[xxxix] the agency has been silent on this particular issue – I guess the IRS is waiting on Congress to act – even as the tax community continues to remind it, as well as Congress, that something needs to be done.[xl]
Earlier this year, for example, the AICPA submitted its 2023 “Compendium of Tax Legislative Proposals” to the Senate Finance Committee and the House Ways and Means Committee.[i]
According to the cover letter that accompanied the Compendium, its focus “is on 61 proposals that are changes to provisions in the Internal Revenue Code that need attention, recommendations that are technical in nature and recommendations that perhaps can be readily addressed.”
Included among these is a request for “legislation to clarify the exclusion of a foreign corporation, which is considered a CFC solely as a result of the “downward attribution” rules . . . , from the definition of a CFC for any U.S. shareholder not considered a related party . . . with respect to the domestic corporation to which ownership was attributed.”[ii]
Until the government acts, it appears that most of the taxpayers affected by this drafting error are following the literal language of the Code as revised by the TCJA; in other words, contrary to the intent of Congress, they are including in their gross income and paying income tax on the Subpart F income and GILTI of foreign corporations that should not be treated as CFCs.
In many cases, such compliance must certainly be an expensive proposition. Query whether any taxpayers are choosing not to include this income for purposes of determining their tax liability, while also disclosing their position and citing the Committee reports and the colloquy from the floor of the Senate described above in support thereof.
Alternatively, are they paying the tax but filing protective refund claims to toll the statute of limitations?[iii]
Perhaps more importantly, are any tax return preparers comfortable with either of the foregoing approaches given the language of the Code and the risk of penalties?[iv]
Or has Congress changed its mind regarding downward attribution?
[i] See below.
[ii] IRC Sec. 61(a) (“…from whatever source derived…”). The sourcing rules are found in IRC Sec. 861 through 865.
Most U.S. tax treaties include a so-called “savings clause” that allows the U.S. to tax its residents as if the treaty were not in force. This provision is intended to prevent U.S. residents from using a treaty to reduce their U.S. income tax liability. See Article 1, Paragraph 4 of the U.S. Model Income Tax Convention.
[iii] This includes a foreign “eligible” entity that is owned by a U.S. business and has elected to be treated as a disregarded entity for U.S. tax purposes. Reg. Sec. 301.7701-3; IRS Form 8832, Entity Classification Election.
[iv] Each is “transparent” for tax purposes – a passthrough. See IRC Sec. 701 and 702 as to partnerships.
[v] For an analogous provision, see the personal holding company rules under IRC Sec. 541 through Sec. 547. The Code imposes a 20% tax (same as the tax on a dividend distribution to an individual shareholder) on the undistributed personal holding company income of a personal holding company. The purpose of the tax, as in the case of the accumulated earnings tax IRC Sec. 531 through Sec. 537), is to prevent the “improper” deferral of taxation of corporate income at the level of the corporation’s shareholders where the corporation fails to pay dividends.
[vi] IRC Sec. 951 through Sec. 965.
[vii] Implicit in the foregoing requirement is the ability – alluded to earlier – of those U.S. persons to whom the CFC’s income is taxed to compel, or withhold, the distribution of such income by the foreign corporation.
This premise is also stated elsewhere in Subpart F; for example, the Code provides that no part of the earnings and profits of a CFC for any taxable year shall be included in earnings and profits for purposes of determining Subpart F income if it is established to the satisfaction of the IRS that such earnings and profits could not have been distributed by the CFC to U. S. shareholders who own stock of such CFC because of currency or other restrictions or limitations imposed under the laws of any foreign country. IRC Sec. 964(b) – i.e., where there was no decision by the U.S. owners to forego a distribution and thereby intentionally defer U.S. tax.
[viii] IRC Sec. 958(a).
[ix] IRC Sec. 958(b).
[x] IRC Sec. 957(a).
[xi] IRC Sec. 951(b) and Sec. 957.
[xii] For most U.S. shareholders, Subpart F income generally includes “foreign base company income” [IRC Sec. 954], which consists of “foreign personal holding company income” (such as dividends, interest, rents, and royalties), and certain categories of income from business operations that involve transactions with “related persons,” including “foreign base company sales income” and “foreign base company services income.”
Specifically, foreign base company sales income is income derived by a CFC from a purchase or sale of personal property involving a related party in which the property is both manufactured and sold for use/consumption outside the CFC’s country of organization [IRC Sec. 954(d)], and foreign base company services income is income derived by a CFC in connection with the performance of services outside the CFC’s country of organization for or on behalf of a related person. [IRC Sec. 954(e).]
However, the pro rata amount that a U.S. shareholder of a CFC is required to report as Subpart F income of the CFC for any taxable year cannot exceed the CFC’s current earnings and profits. [IRC Sec. 952(c)(1)(A).] After all, the purpose of Subpart F is to deny deferral of U.S. taxation; it cannot require that a U.S. shareholder of a CFC be taxed on amounts in excess of the dividends they would have received if all of the CFC’s income had been distributed currently. [IRC Sec. 964.]
One exception to the definition of Subpart F income permits continued U.S.-tax-deferral for income received by a CFC in certain transactions with a related corporation organized and operating in the same foreign country in which the CFC is organized (the “same country exception”).
Another exception is available for any item of income received by a CFC if the taxpayer establishes that the income was subject to an effective foreign income tax rate greater than 90% of the maximum U.S. corporate income tax rate (the “high-tax exception”). In theory, the 21% U.S. federal corporate income tax rate should make it easier to qualify for this exception.
In 2017, the TCJA introduced a new class of income – global intangible low-taxed income (“GILTI”) – that must be included in the gross income of a U.S. shareholder of a CFC, and which further eroded a U.S. person’s ability to defer the U.S. taxation of foreign-sourced business income.
This provision requires the current inclusion in income by a U.S. shareholder of (i) their share of all of a CFC’s non-Subpart F income (other than income that is excluded from foreign base company income by reason of the “high-tax” exception [IRC Sec. 954(b)(4)], (ii) less an amount equal to the U.S. shareholder’s share of 10% of the adjusted basis of the CFC’s tangible property used in its trade or business and of a type with respect to which a depreciation deduction is generally allowable; the difference is the shareholder’s GILTI. [IRC Sec. 951A.]
In the case of an individual, the maximum federal tax rate on GILTI is 37%. This is the rate that will apply, for example, to a U.S. citizen who directly owns at least 10% of the stock of a CFC.
More forgiving rules apply in the case of a U.S. shareholder that is a C corporation. For taxable years beginning after December 31, 2017, and before January 1, 2026, a regular domestic C corporation is generally allowed a deduction of an amount equal to 50% of its GILTI; thus, the federal corporate tax rate for GILTI is actually 10.5% (the 21% flat rate multiplied by 50%). [IRC Sec. 250(a)(1)(B).] However, see the election under IRC Sec. 962.
[xiii] IRC Sec. 951(a). In effect, the Code treats the U.S. Shareholder of a CFC as having received a current distribution of their share of the CFC’s Subpart F income.
[xiv] An actual or deemed shareholder.
[xv] IRC Sec. 318(a)(2)(C), as modified by IRC Sec. 958(b)(2) and (3).
[xvi] The shareholder.
[xvii] IRC Sec. 318(a)(3)(C).
[xviii] The “TCJA”; Pub. L. 115-97.
[xix] The ownership attribution rules for determining constructive ownership of corporate stock under IRC Sec. 318 and former Sec. 958(b)(4).
[xx] Former IRC Sec. 958(b)(4)’s application of IRC Sec. 318(a)(3)(C).
[xxi] Similarly, see IRC Sec. 958(b)(1), which provides that in applying the family attribution rules of IRC Sec. 318(a), stock owned by a nonresident alien individual (other than a foreign trust or foreign estate) shall not be considered as owned by a U.S. citizen or by a resident alien individual.
[xxii] You may recall that the TCJA was passed using the Senate’s Budget Reconciliation Procedure. The Democrats were not happy campers – the legislation was pushed through strictly along party lines.
[xxiii] See below.
[xxiv] IRC Sec. 958(b)(4).
[xxv] The provision was effective for the last taxable year of a foreign corporation beginning before January 1, 2018, and for each subsequent year of such foreign corporation, and for the taxable years of U.S. shareholders in which or with which the taxable years of such foreign corporation ends.
[xxvi] Sec. 14213 of the TCJA.
[xxvii] The TCJA amended IRC Sec. 958(b) by striking paragraph (4) – the anti-downward attribution rule – in its entirety.
[xxviii] “Reconciliation Recommendations Pursuant to H. Con. Res. 71,” S. Prt. 115– 20, December 2017, p. 378 ; see the website of the Senate Budget Committee.
The House version of the bill also amended the ownership attribution rules of section 958(b) so that certain stock of a foreign corporation owned by a foreign person would be attributed to a related U.S. person for purposes of determining whether the related U.S. person was a U.S. shareholder of the foreign corporation and, therefore, whether the foreign corporation was a CFC. In other words, the provision provided “downward attribution” from a foreign person to a related U.S. person in circumstances in which then-present law did not so provide.
[xxix] Conference Report to H.R. 1, H.R. Report 115–466, December 15, 2017, pp. 633–634.
[xxx] Congressional Record Vol. 163, No. 207 (December 19, 2017), Page S 8110, (emph. added).
[xxxi] IRC Sec. 951 and Sec. 951A, respectively.
[xxxii] H.R. 88, Sec. 501(f).
[xxxiii] Sometimes, I quack myself up.
[xxxiv] The CARES Act; P.L. 116-136.
[xxxv] Under what would have been new IRC Sec. 951B.
[xxxvi] Sec. 2209, S. 3548, 116th Cong. (March 19, 2020).
[xxxvii] IRC Sec. 958(b). The BBB would have added a new paragraph (4). Rules Committee Print 117-18, Text of H,R, 5376, Build Back Better Act, Section 138128(b)(3).
[xxxviii] Pub. L. 117-169.
[xxxix] For example, Rev. Proc. 2019-40, and the regulations under T.D. 9908.
[xl] Has the IRS determined that it does not have the authority to act in this instance?
[xli] https://us.aicpa.org/content/dam/aicpa/advocacy/tax/downloadabledocuments/56175896-aicpa-cover-letter-and-compendium-2023.pdf.
