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International Income Taxation Chapter 6: OUTBOUND TAXATION: ANTI-DEFERRAL REGIMES Professor Wells Presentation: March 7, 2016
Transcript

International Income Taxation Chapter 6: OUTBOUND TAXATION: ANTI-DEFERRAL REGIMES Professor Wells

Presentation:

March 7, 2016

2

Chapter 6 – Options for Anti-Deferral Tax Regimes

Alternative approaches to U.S. taxation of U.S. owners & foreign corporate income: 1)  Complete deferral (or territorial?) 2)  Partial deferral – ‘Subpart F” approach 3)  Deferral, but imposition of an interest charge when income

distribution occurs 4)  Deferral, but tax characterization change to ordinary income when

gain is received 5)  No deferral – all current income recognition (or “acceleration”?)

3

Present/Former U.S. Anti-Deferral Tax Structures

1)  FPHC – current attribution of investment income (repealed 2004)

2)  Controlled foreign corporation or CFC-Subpart F provisions – partial current recognition of undistributed income.

3)  Foreign investment companies – (repealed 2004) – characterization of a distribution.

4)  Passive foreign investment company rules – PFIC – interest charge on an excess distribution or on stock sales proceeds.

4

Purposes for Use of “Base Country” Corp. p. 487

US Domestic Subsidiary

Foreign Base Company

Third Country Operations

US Parent

US Domestic Subsidiary

Third County Operations

Foreign Base Company

Foreign-Owned US-Owned Subpart F Inclusion

Subpart F

5

The “Subpart F” Provisions Summarized p. 489

Code §§951-964 Current income taxation to U.S. shareholders (even though income not received.): 1)  Must be a “controlled

foreign corporation” (or CFC)

2)  Must be a 10% or greater shareholder

3)  Limited to certain types of movable income (not manufacturing income).

US Parent

US Domestic Subsidiary

Third County Operations

Foreign Base Company

US-Owned Subpart F Inclusion

6

PFIC Provisions Summarized p. 490

Code §§1291-1298 (TRA-1986) “Passive Foreign Investment Company” (or PFIC) status – income must be 75% passive (or 50% of assets producing passive income). No minimum stock ownership required. Deferral permitted since no CFC status, but the benefit of the income tax deferral is recaptured (through an interest charge) when “excess distribution” or a stock sale.

1)  Qualified electing fund 2)  “Mark to Market” for PFIC stock –

assuming marketable stock.

Foreign Investment Fund

PFIC Other

Investors US

Person

7

“Temporary” Dividends Received Deduction p. 492

Code §965 – temporary (2004) provision enabling an 85% DRD. Therefore, tax of 35% times 15% = 5.25% Only cash dividends. Must be extraordinary dividends (i.e., exceeding average repatriations) Reinvestment in U.S. required – must be a dividend investment plan and funds are to be used for prescribed purposes.

US Parent

Foreign Base Company

$100 Dividend <$85> DRD $15 Taxable

8

Definition of a “Controlled Foreign Corporation” p. 494

Code §957(a) defines a “controlled foreign corporation” (CFC) as a foreign corporation where more than 50 percent of (i)  the vote, or

(ii)  the value of all the outstanding stock is owned (or considered as owned) by “United States shareholders” on any day during the taxable year.

US Parent

Controlled Foreign Company

Foreign Investor

< 50% vote or value

9

“United States Shareholder” Defined p. 494

Who are “United States shareholders”? See the §951(b) definition. U.S citizens, resident aliens, corporations, partnerships, trusts or estates owning directly or indirectly or constructively (under the ownership rules of §958) 10% or more of the total combined voting power of all classes of stock or a foreign corporation. Less than 10%: a “portfolio interest”.

10

Subpart F Constructive Dividends Concept p. 496

1)  Include a pro rata share of “Subpart F income” (§951(a)(1)(A)(i)), as determined on the last day of the year. Objective: Constructive receipt – economic power to control the income and an immediate accretion to wealth causes inclusion.

2)  Include pro rata share of investment in “U.S. Property” (§956) – a deemed repatriation of profits (income type is not relevant).

3)  Income attributed to the shareholder is treated as ordinary income (i.e., capital gain may be transformed into ordinary income). Relevant to an individual. Cf., branch treatment.

4)  No loss pass-through to the shareholder.

5)  Subsequent stock disposition gain – ordinary income to the extent of allocable profits. §1248 (i.e., no capital gain).

11

Subpart F – Foreign Tax Credit Availability p. 498

Indirect foreign tax credit is available for U.S. corporate shareholders when current inclusion – similar to §902. See §960. §78 gross-up by the taxes deemed paid attributable to the deemed distribution. §962 – elective treatment to an individual shareholder for the same treatment (i.e., availability of the deemed paid foreign tax credit and tax at corporate rates).

12

Subpart F – Adjustment Mechanisms p. 499

§959(a) – actual distributions from the CFC are sourced first from amounts already taxed under §951(a). Similar for previously taxed §956 U.S. investment amounts. §961(a) – an increase in tax basis is made for shares by the amount included in gross income under §951(a). Reduction of tax basis is made for untaxed distributions. §961(b).

13

Subpart F Income Elements - §952(a) p. 499

1)  “Foreign base company income” – diversion of passive (and other) income to a low-tax jurisdiction.

2)  Income from insurance activities.

3)  International boycott-related income.

4)  Illegal bribes and kickbacks.

5)  Bad country income.

US Parent

US Domestic Subsidiary

Foreign Base Company

US-Owned

Subpart F

Subpart F Inclusion

14

Foreign Base Company Income - §954(a) p. 500

Categories of FBC Income: 1)  Foreign personal holding company

income (FPHCI)

2)  Foreign base company sales income (FBC sales income).

3)  Foreign base company services income (FBC services income).

4)  Foreign base company oil related income. Not active business income; formerly, also, foreign base company shipping income.

US Parent

US Domestic Subsidiary

Foreign Base Company

US-Owned

Subpart F

Subpart F Inclusion

15

Limits on Subpart F Income Inclusion p. 502

1)  §954(b)(3) de minimis rule (5%) but, also, a 70% full inclusions rule.

2)  §952(c)(1) provides limit on CFC’s Subpart F income to “earnings and profits” for that year.

3)  §952(b) excludes from Subpart F income certain U.S. source income – ECI with a U.S. trade or business (currently subject to U.S. income tax).

16

Definition of “Controlled Foreign Corporation” p. 502

§957 – more than 50% vote or value of the corp. stock is owned by U.S. shareholders. §958 specifies direct, indirect and constructive ownership rules. §958(a)(2) – indirect ownership rules §958(b) – constructive ownership rules concerning attribution between family members and between (i) entities and (ii) their shareholders, partners or beneficiaries. Cf., §318 (Subchapter C).

17

Problem 1 p. 504 CFC Status?

Zeus, a Swiss corporation, has 1,000 shares of a single class of stock outstanding. Jupiter, a widely held U.S. corporation, owns 460 shares and the remaining 540 are owned equally by six unrelated U.S. individuals. Result: None of the individuals is a “U.S. shareholder” because none owns 10% and Zeus is not a CFC. §957(a) and §951(b).

Zeus Swiss Corp

Jupiter US Corp

US Person #1

US Person #2

US Person #3

US Person #4

US Person #5

US Person #6

460 90 90 90 90 90 90

18

Problem 2 p. 504 More than 10% Individuals

The number of shareholders is reduced from six to five. Each individual shareholder then owns more than 10 percent (10.8%, or 108/1000). Result: Each individual would be a “U.S. shareholder”. Therefore, Zeus would be a CFC (more than 50% of its stock is owned by “U.S. shareholders”).

Zeus Swiss Corp

Jupiter US Corp

US Person #1

US Person #2

US Person #3

US Person #4

US Person #5

460 108 108 108 108 108

19

Problem 3 p. 504 Attribution to Partnership

A partnership (one of six shareholders each owning 9%) owns 90 shares and a partner owns 90 shares. The partner’s shares are attributed to the partnership and the partnership, therefore, holds 180 shares. Zeus is a CFC (when including Jupiter’s shares). §958(b) and §318(a)(3)(A). 180 plus 460 (640) is more than 50 percent. Is the partner a U.S. shareholder? No, §318(a)(2) (5% of 90 shares = 4.5 shares).

Zeus Swiss Corp

Jupiter US Corp

US Person #1

US Person #2

US Person #3

US Person #4

US Person #5

US Partnership

460 90 90 90 90

90

90

5%

20

Problem 4 p. 504 Husband and Wife Attribution

Two of the individuals are husband and wife. Each spouse’s shares are attributed to the other under §958(b) and §318(a)(1)(A)(i). Each spouse is deemed to own 180 share (90 actually and 90 by attribution) and each spouse is a U.S. shareholder. Therefore, Zeus is a CFC (when the 180 shares are combined with the 460 Jupiter shares = 640).

Zeus Swiss Corp

Jupiter US Corp

US Wife

US Husband

US Person #3

US Person #4

US Person #5

US Person #6

460 90 90 90 90 90 90

21

Problem 5 p. 504 Nonresident Alien Status

Two of the individual shareholders are husband and wife. One spouse is a nonresident alien. No attribution occurs (under §318(a)(1)(A)) to/from a nonresident alien spouse. See §958(b)(1). Therefore, Zeus is not a CFC.

Zeus Swiss Corp

Jupiter US Corp

Foreign Wife

US Husband

US Person #3

US Person #4

US Person #5

US Person #6

460 90 90 90 90 90 90

22

Problem 6 p. 505 Attribution Among Siblings?

Two of the individuals are brother and sister. No attribution occurs between siblings under §318(a)(1)(A). Therefore, Zeus is not a CFC. What if Father is still alive and is a US citizen? Arguably Zeus would be a CFC via attribution of shares to Father.. Cf., §554(a)(2) of the (former) foreign personal holding company provisions.

Zeus Swiss Corp

Jupiter US Corp

US Sister

US Brother

US Person #3

US Person #4

US Person #5

US Person #6

460 90 90 90 90 90 90

23

Problem 7 p. 505 Corp./Shareholder Attribution

One of the individuals (owning 90 shares owns 50 percent of the stock of Jupiter Corporation (which owns 46% of Zeus).

Two Methods: Method #1: All of the individual’s 90 shares are attributed from individual to Jupiter Corp. and Jupiter then owns 550 shares (460 + 90). §318(a)(3)(C). Zeus is a CFC. Method #2: 50% of Jupiter’s shares are to individual partners (yes, ½ of 460 shares). §318(a)(2)(C). U.S. Person #1 constructively owns 320 shares (230 plus 90 = 320). Bottom Line: Method #1 trumps since it creates greater ownership. See

Treas. Reg. §1.958-2(f)(2)

Zeus Swiss Corp

Jupiter US Corp US

Person#2 US

Person #3 US

Person #4 US

Person #5 US

Person #6

460

90

90 90 90 90 90

50% US

Person #1

24

Problem 8 p. 505 10% Share Ownership

One of the individuals (owning 90 shares) owns 10% (not 50%) of the stock of Jupiter Corporation (which owns 46% of Zeus) and becomes U.S. shareholder. Analysis: 1.  No attribution to Jupiter from US Person #1 because Jupiter is less than

50% owned by US Person #1. See §318(a)(3)(C). 2.  Attribution from Jupiter to US Person #1 of 46 shares so that US Person

#1 is considered a US shareholder. §318(a)(2)(C) modified by §958(b)(3). Bottom Line: The 2 US Shareholders (Jupiter & US Person #1) own togethr 550 shares (i.e., Jupiter owns 460 and US Person #1 owns 90).

Zeus Swiss Corp

Jupiter US Corp

US Person #1

US Person #2

US Person #3

US Person #4

US Person #5

US Person #6

460

90

90 90 90 90 90

10%

25

Problem 9 p. 505 5% Share Ownership

One of the individuals (owning 90 shares) owns 5% of the stock of Jupiter Corporation (which owns 46% of Zeus). Analysis: 1.  No attribution from US Person #1 to Jupiter because US Person #1 owns

less than 50% of Jupiter. See §318(a)(3)(C). 2.  The Jupiter shares are not attributed to US Person #1 since US Person #1

owns less than 10% of Jupiter. See §318(a)(2)(C) & §958(b)(3). Bottom Line: Zeus is not a CFC since Jupiter is the only “U.S. shareholder”.

Zeus Swiss Corp

Jupiter US Corp

US Person #1

US Person #2

US Person #3

US Person #4

US Person #5

US Person #6

460

90

90 90 90 90 90

5%

26

Problem 10 p. 505 Ownership Through Foreign Corp.

410 shares of Zeus are owned by Jupiter Corp. and 90 shares are owned by a U.S. citizen who (1) also owns 3% of the shares of Juno B.V. (a Dutch corporation) that (2) owns 500 Zeus shares (i.e., U.S. citizen indirectly owns 15 additional shares of Zeus or a total of 105). Analysis: 1.  Neither §318(a)(2)(C) or §318(a)(3)(C) would provide attribution. 2.  But, §958(a)(2) has a special attribution rule for foreign entities. US Person

#1 is deemed to actually own its pro rata share of Juno’s shares in Zeus, so 105 total shares (90 + 3% of 500).

Bottom Line: 105 shares plus 410 shares means Zeus is a CFC.

Zeus Swiss Corp

Jupiter US Corp

US Person #1

410

90 3%

Juno Dutch Corp

500

27

Stock Voting Power (or Value?) Test – 50% Plus

CCA, Inc. P. 505 Old CCA owned all of the issued and outstanding stock of AG (Swiss). AG was exporter of CCA products from the United States. Also, AG had exclusive right to use CCA trademarks. AG had manufacturing plants in other European jurisdictions. After 1962, an objective to “decontrol” AG. Accomplished here? Yes. Why?

Control A.G. (Swiss)

Controls Co. (US)

800 c.s.

Swiss Credit Bank (Swiss)

400 Pfd

Control A.G. (Swiss)

400 Pfd

28

Koehring Case p. 515 Nominal Control Irrelevant

KOS, a Panamanian sub, operating as a wholly owned sub of the U.S. parent corporation. Voting control transferred to Newton Chambers, an English company. Purchase of cumulative voting preferred stock having 55% of the vote. See Reg. §1.957-1(b)(2) re shifting of formal voting power. But, KOS treated as a CFC. Why?

Koehring Overseas Corp (Panama)

Koehring Corp. (US)

36,000 c.s.

Newton Chambers (U.K.)

44,000 Pfd

29

Problem 4 p. 526 Avoiding CFC Status

Still possible to decontrol foreign corp.? Yes, but preferred stock must have vote and value (see §957(a)(2)) equal to at least 50%, and: 1)  Restrictions re no transfer to U.S. person 2)  50 percent of the Board of Directors as preferred share

representatives. 3)  No commitment to redeem preferred. 4)  No means to resolve the deadlocks, etc.

30

Stapled Stock Corporations p. 527

Holdings in (1) the U.S. and (2) the foreign corporations can only trade as a unit. “Stapling” to avoid the applicability of the Subpart F rules for the foreign corp. and sufficiently wide distribution of shares of the foreign corporation to not be a CFC. §269B specifies that the foreign corporation when stapled is treated as a U.S. corporation. Cf., a nonstapled corp.

31

Corporate Inversions p. 529

Transformation of a U.S. publicly traded corporation into a subsidiary of a foreign corporation. After the transaction the U.S. shareholder ownership is widely dispersed and the foreign corporation is not a CFC. Stripping profits from the U.S. sub to foreign parent would then be enabled. May be treated as a U.S. corp. See §7874.

US Domestic Subsidiary

Inverted Parent

Third Country Operations

Third Country Operations

Dotted line denotes scope of US international tax rules

US Domestic Subsidiary

Foreign-Owned Parent

Third Country Operations

Foreign-Owned Inverted-Owned

32

Rules for Corporate Residency p. 529

Base the corporate residency status determination on where the primary corporate officers reside (rather than the place of organization)? Cf., other foreign country tests of the place of “management and control” for determining the situs of a corporation. Different from the place where corporate business is conducted?

33

Mechanics of Subpart F p. 530 Income Inclusion

§951(a)(1) – gross income inclusion if corporation is a CFC for a 30 day period. Every person who is a U.S. shareholder must include his/her/its pro rata share of Subpart F income at year-end. Pro rata share of includible Subpart F income is determined by reference only to direct and indirect CFC ownership (but not to constructive ownership).

34

Subpart F. Mechanics, Continued

If CFC for only part of the year – pro rata allocation. §951(a)(2)(A). Reduction of Subpart F income amount if dividends actually received earlier in same year by prior owner. §951(a)(2)(B). Note: How negotiate a corporate acquisition transaction with this Subpart F income consideration? Dividend or no dividend treatment? Consider the FTC situation.

35

Subpart F Income Inclusion, Continued p. 532

If multiple classes of stock outstanding, how allocate the Subpart F income among the several classes? Allocation based on E&P amounts allocable to each class. How allocate income if directors have discretionary power to allocate income among the several classes of stock? Based on relative values of the shares. 2005 Regulations – T.D. 9222 (8-25-2005).

36

Subpart F Income Inclusions, Multiple Tiers p. 533

If multiple tiers of corporations, how determine the shareholder’s Subpart F income amount? Use the “hopscotch method” for Subpart F income from lower corps. Eligibility for (indirect) foreign tax credit? Yes Gross-up Subpart F income amount under §960. Shareholder increases tax basis for above tier corps. What happens when 1st tier corporation sells shares of 2nd tier corporation? Tax basis increase for holding in 2nd tier sub. §961.

CFC #1

US Parent

CFC #2 FS #2

Gen. E&P Tax Pool $800 $80 Sub. F <$200> <$20> Ending $600 $60

FS #1 Gen. E&P Tax Pool $800 $400

Compare to actual dividends (see p. 368)

37

Foreign Tax Credit Availability p. 535

§960 – similar to §902 concerning availability of the indirect FTC. Indirect credit available down to 6th tier foreign corporation is a controlled foreign corporation. §902(b)(2). At least 10% ownership of voting stock at each level. No indirect FTC below the 6th tier.

38

Problem 1 p. 537 FBC Income Allocation

Two NRAs and a U.S. corporation organize Irish Foreign Base Company, Inc. (FBC). On August 8 NRA Molly gets a “green card”. FBC has net income of $400,000 for year one – ½ being Subpart F income. FBC paid $80,000 in foreign income tax on pre-tax foreign net income of $480,000 (16% rate). FBC becomes a CFC on August 8 when FBC has a 40% and a 30% U.S. shareholder. For the year, $200,000 is Subpart F income (§954(b)(5)). Proportionate allocation of Subpart F income to be made to the period during which the corporation is a CFC – 40% (146/365) of the year, times $200,000 ($80,000), equals $32,000 inclusion for Widgets (40%) and $24,000 for Molly (30%). Molly tax basis adjustment for her stock: $30,000 plus $24,000 Subpart F income - $54,000. No indirect FTC (since an individual), assuming no §962 election. Widget’s tax basis increase for stock: $40,000 plus $32,000 Subpart F income = $72,000 basis. Widgets gets §960 deemed paid credit: 32,000/400,000 x 80,000 = 6,400. No tax basis increase for the 6,400 amount (since used as a FTC).

39

Problem 2 p. 537 Actual Dividend Distribution

Year two distribution of dividends from FBC: $20,000 to Widgets and $15,000 to Molly and Sam. FBC breaks even for 2nd year. Sam (foreigner) is not subject to U.S. tax. Under §959 no tax to Widgets and Molly since paid out of earnings previously taxed (under §951). See §959(c) ordering rules. Under §961(b) share basis is reduced (prior increase upon the earlier income inclusion).

40

Exclusion of U.S. Trade or Business Income p. 537-538

§952(b) exclusion from Subpart F. Assumption of net basis income taxation in the United States. No exclusion from Subpart F, however, where trade or business income in U.S. (1) is entitled to exclusion (e.g., no P.E.) under tax treaty, or (2) has a reduced rate of tax under income tax treaty.

41

Subpart F Income is Based on Current E&P

§952(c)(1)(A) – Subpart F income limited to current “earnings and profits”. Some CFC current losses may reduce CFC’s Subpart F income. Possible subsequent recharacterization when excess of current earnings and profits realized over Subpart F income. §952(c)(2). A timing rule.

42

Accumulated Deficits As Reducing Subpart F Income

Accumulated deficits do not reduce Subpart F income for the current year, except as permitted in §952(c)(1)(B) (i.e., “qualified activity”). Deficits in related companies cannot be used to reduce Subpart F income except where the same “qualified activity” is conducted by a “qualified chain member”.

43

Defining Foreign Base Company Income p. 540

Definition of FBCI in §954(a): 1)  Foreign personal holding company income. Same country

exceptions.

2)  Foreign base company sales income.

3)  Foreign base company services income.

4)  Foreign base company oil related income.

FBCI formerly included foreign base company shipping income.

44

Defining Foreign Personal Holding Company Income

General Rule set forth in in §954(c) – FPHCI includes interest, dividends, rents, royalties, annuities and gains from the sale of stock or securities.

Principle: Passive income can be earned anywhere, so there should not be a tax advantage to make this easily portable income to be earned in a foreign subsidiary where the need for the foreign subsidiary as the investor is slight. The possible competitiveness argument for deferral of “active business income” does not apply to passive investments. continued

US Parent (US)

UK Holdings (UK)

Interest, Dividends, Rents, Royalties, & Annuities Payors

45

Defining Foreign Personal Holding Company Income

Exception #1: Active Rents and Royalties Exception of §954(c)(2)(A)(i). FPCHI does not include rents & royalties from unrelated persons when derived in the active conduct of a business - §954(c)(2)(A).

Principle: Active business income is not the portable income that we are concerned about. The possible competitiveness argument for deferral of “active business income” applies with more force here.

continued

US Parent (US)

UK Holdings (UK) Active Rents & Royalties

Unrelated Payors

46

Defining Foreign Personal Holding Company Income

Exception #2: Active Banking, Financing, or Similar Business of §954(h). FPCHI does not include includes interest, dividends, rents, royalties, annuities and gains from the sale of stock or securities if earned as part of an active banking or financing business. Principle: Active business income is not the portable income that we are concerned about. The possible competitiveness argument for deferral of “active business income” applies with more force here. Some argue that this exception allows G.E. & others a significant opportunity to completely end-run the FPHCI rules. continued

US Parent (US)

Capital Markets (UK)

Active Banking: Interest, Dividends, Rents, Royalties, & Annuities

Unrelated Payors

47

Defining FPHCI, Continued p. 542-4

Exception #3: Related party “Same Country Exception” of §954(c)(3). FPCHI does not include certain interest & dividends (incorporation test) and certain rents & royalties (country of use test) that meet the “same country” requirements. Gain on sale by CFC of another CFC stock (including §311(b) gain) is treated as a “dividend” per §954(c)(3)(C)/§964(e). Principle: These same country payments are not the type of “tax haven” activities that motivated curtailment of the deferral privilege.

Exception to Exception #3: Same country exception doesn’t apply to related party payments that reduce the payor’s Subpart F income.

See §954(c)(3)(B).

UK Op Co (UK)

UK Holdings (UK)

Dotted line denotes activity all within UK

Dividends & Interest

48

Defining FPHCI, Continued p. 542-4 (Intermediate Holding Company Structure: “Homeless Income Generator”)

Exception #4: Hybrid Entity Structures. FPHCI only applies to payments that are treated as interest, dividends, rents and royalties for US tax purposes. A hybrid entity is a separate entity for foreign tax purposes but (2) a conduit/branch/disregarded entity for U.S. income tax.

Principle: Payment from a disregarded entity (a “non-entity” for US tax purposes) are “non-events” for US tax purposes and thus are not payments of “interest,” “rents,” “royalties,” or “dividends.”

Intermediate Hold Co. (Luxembourg/Netherlands/

Ireland/Switzerland)

Dividends, Interest, Rents, Royalties

Third Country Operations

Third Country Operations

Dividends, Interest, Rents, Royalties

Non-Events

US Parent (US)

Preferred Equity Certificates

SourceofChart:BasedonJCTReportontheTaxTreatmentofBusinessDebt(July2011)

Holdco Functions: IP, Funding, Risk = Residual Foreign Profit

Routine Profit

49

Defining FPHCI, Continued p. 542-4

Possible Exception #5?: The “Temporary” CFC Exception of §954(c)(6). FPHCI includes dividends, interest, rents and royalties paid between CFCs that are not incorporated in the same country, but §954(c)(6) has allowed an exception now to 2020. Will this exception be extended further????? Principle: Once Congress chose to not attack the check-the-box exception, Congress found it difficult to argue against this exception. This provision has been a ping pong ball bounced back and forth but in Protecting Americans From Tax Hikes Act of 2015 this provision was extended to 2020.

Intermediate Foreign HoldCo (Netherlands)

Dividends, Interest, Rents, Royalties

Third Country Operations

Third Country Operations

Dividends, Interest, Rents, Royalties

50

Related Person Factoring Income p. 546

Sale of receivable to a “factor” at a discount. §864(d)(1) – discount income from factoring with a related person is treated as “interest” income from a loan. Also, a loan to a purchaser from a related party is treated as a receivable purchase for this rule. §864(d)(6). A same country exception is available in some situations. §864(d)(7).

51

Other Foreign Personal Holding Company Income

Foreign currency gains. §954(c)(1)(D). Hedging exception is applicable. Income from commodity transactions. §954(c)(1)(C). Hedging exception available. §954(c)(5)(A). Income derived fro the sale of property producing (1) passive income or (2) no income. §954(c)(1)(B).

52

The “Check & Sell” Plan p. 552 The Dover Case

CFC’s sale of stock (including the stock of a 2nd tier foreign subsidiary) produces capital gain which is FPHC income. Sale of assets produces no FPHCI but may cause foreign country gains tax. Option: Use “check the box” entity characterization rules (assuming an “eligible entity”) to cause a deemed liquidation of the foreign corp.

US Parent

Unwanted Subsidiary

Foreign Base Company

Case #1: FPHCI Stock Gain US

Parent

Unwanted Subsidiary

Foreign Base Company

Case #2: No FPHCI Stock Gain

Nonsubpart F

Buyer Cash Buyer Cash

Subpart F

53

Foreign Base Company Sales Income p. 556

§954(d). Two Part Test Income derived from the purchase and the sale of personal property:

(1)  If purchased from or sold to a related party, (Test #1) and (2)  The property was manufactured or produced outside the country

where the CFC is organized and the property is sold for ultimate use outside of country where CFC is organized. (Test #2)

Includes income from sales or purchase commissions. Exception: Agricultural commodities not grown in the US in commercial

quantities are exempt from FBSCI rules (discuss the coffee classification) “Tax avoidance” purpose not relevant.

54

Foreign Base Company Sales Income p. 556

US Parent

Brazilian Subsidiary

Foreign Base Company Sale

Sale

No

Case #1: Brazilian Orange Juice

Unrelated U.K. Customer

Yes

ü  §954(d). Two Part Test Income derived from the purchase and the sale of personal property:

(1)  If purchased from or sold to a related party, (Test #1) and (2)  The property was manufactured or produced outside the country

where the CFC is organized and the property is sold for ultimate use outside of country where CFC is organized. (Test #2)

55

Foreign Base Company Sales Income p. 556

US Parent

Uruguay Subsidiary

Foreign Base Company Sale

Sale

Yes

Case #2: Brazilian Orange Juice

Unrelated U.K. Customer

Yes ü  ü 

§954(d). Two Part Test Income derived from the purchase and the sale of personal property:

(1)  If purchased from or sold to a related party, (Test #1) and (2)  The property was manufactured or produced outside the country

where the CFC is organized and the property is sold for ultimate use outside of country where CFC is organized. (Test #2)

56

Foreign Base Company Sales Income p. 556

US Parent

Uruguay Subsidiary

Foreign Base Company Sale Sale Yes

Case #3: Brazilian Orange Juice

Unrelated Customer

No

Unrelated Brazilian Exporter

Purchase Commission

ü  §954(d). Two Part Test Income derived from the purchase and the sale of personal property:

(1)  If purchased from or sold to a related party, (Test #1) and (2)  The property was manufactured or produced or produced outside

the country where the CFC is organized and the property is sold for ultimate use outside of country where CFC is organized. (Test #2)

57

Foreign Base Company Sales Income p. 556

US Parent

Foreign Base Company Sale Sale

Case #4: Brazilian Orange Juice

UK Customer

No

Unrelated Brazilian Exporter

U.K. Subsidiary

Sale

Yes

Question: How do you remove All subpart F in this pattern?

ü  §954(d). Two Part Test Income derived from the purchase and the sale of personal property:

(1)  If purchased from or sold to a related party, (Test #1) and (2)  The property was manufactured or produced outside the country

where the CFC is organized and the property is sold for ultimate use outside of country where CFC is organized. (Test #2)

58

Foreign Base Company Sales Income, Continued

Exception from FBC sales income treatment where CFC conducts significant manufacturing of the product sold:

What is “manufacturing”? Must be “substantial transformation”; 20%+ “safe-harbor” possible for the CFC. Minor assembling is not sufficient to constitute “manufacturing”.

Fischbein case (later, Ch. 11, p. 825).

continued

US Parent

Brazilian Subsidiary

Foreign Base Company Sale Sale

No

Unrelated U.K. Customer

No?

Brazilian Farmer

U.K. Distribution

Subsidiary Sale

No

Purchase Agent + Toll Processor/ Commissionaire

59

Foreign Base Company Sales Income Continued p. 558

Possible application of a “branch rule” i.e., treating the branch as a separate corporation. §954(d)(2). Why?

Example: Swiss CFC engaged in manufacturing and using a Cayman Islands branch as the sales operation. Tax only in Switzerland on the manufacturing income (territorial approach). No tax in Cayman Islands on the sales activity (and income). CI branch is treated as a “subsidiary” for subpart F testing purposes.

US Parent

Foreign Base Company Sale

Case: Swiss Company Manfactures Swiss Watches

UK Customer

Manufacture in Switzerland

Unrelated Supplier

Cayman Sales Branch Sale Watches

Treat As Separate Sales Subsidiary

60

Foreign Base Company Services Income p. 559

§954(e)(1). Services performed (1) for a related person and (2) performed outside the country where the CFC is organized. Both a “related person” and a “geographic” test need to be satisfied.

Consider foreign construction or drilling companies engaged in offshore activities. “Substantial assistance” to the affiliate subsidiary may cause this rule to apply.

US Parent

Foreign Base Company

Unrelated E&P Customer in Angola

Rig Co. (US Sub)

Lease Personnel Charge

Case: Drilling Operations in Angola for Major E&P Company

61

Foreign Base Company Oil Related Income p. 561

§954(g)(1). “Oil related” income realized by big producers outside the country of oil and gas production. E.g., refining, transportation and distribution income from oil and gas products. See §907(c)(2)&(3). Applicable only to large producers (1,000+ barrels per day). Exception for in country consumption.

62

Subpart F Definition of a “Related Person” p. 562

§954(d)(3) specifies that a “related person” is one of the following: 1)  More than 50% of the vote or value of a controlled corporation.

2)  More than 50% of value of the beneficial interests in a partnership, trust or estate.

63

Special Rules for Inclusion/Exclusion p. 563

1)  De minimis rule (lesser of 5% or 1 mil; e.g., for interest received on cash balances). §954(b)(3)(A).

2)  Full inclusion (70%+) rule. §954(b)(3)(B).

3)  Exception for a high-taxed income item. §954(b)(4). At least a 31.5% (effective, not nominal) tax rate. No PLR is available.

Blocked earnings exclusion. §964(b); but, note re swap and similar arrangements.

64

Income Earned by CFC Through Partnership p. 568

Consider Subpart F income realized by a partnership – attribution to the partners, including to a CFC (sub of a US parent)? 1.  §702 provides for separate characterization. But see

Brown Group cases. Congress shut-down the Brown Group technique by amending §954(d)(3) to treat partnerships as related parties for testing purposes.

2.  §701 anti-abuse regulations give further authority to treat a partnership as an “aggregate”.

3.  Notice 96-39 states IRS won’t follow Brown Group 8th Cir. opinion. p. 568

4.  Subsequent regulations issued in 2002 attempt to overturn the Brown Group analysis by mandating an aggregate approach. See Treas. Reg. §1.702-1(a)(8)(ii)

5.  §954(c)(4) added in 2004 applies aggregate approach to characterize the sale of a partnership interest as FPHCI or not depending on underlying partnership assets (a look-through approach).

US Parent

CFC

Unrelated Supplier

USS P

Brinco

Sale

65

Subpart F and The New Economy p. 573

U.S. Treasury Department Study, 12-2000 Impact of the Subpart F rules on transactions conducted through websites and the internet. Sourcing issues: Where is the place of performance or the place of use? Sales of goods? Royalties? Services? Manufacturing within the CFC, e.g., for software? Relevance of “branch rules”? Or, “U.S. trade or business status”?

66

Problem 1a p. 581 Matterhorn, S.A. Swiss Sub of USM (U.S)

Matterhorn (a CFC) acquires from parent and sublicenses patents for royalties to be received from independent licensees outside Matterhorn’s place of organization. Question: Do these royalties create FPHCI?

Answer: Yes, these royalties included in definition of FPHCI unless: (i) same country-related person exception under §954(c)(3)(A)(ii) or (ii) the active business – unrelated person exception of §954(c)(2)(A). Neither apply absent additional facts.

USM (US)

Matterhorn (Swiss)

Unrelated Supplier IP Licensing

Royalties

67

Problem 1b p. 581 Matterhorn

Matterhorn patents are acquired from inventions developed by Matterhorn’s own technicians.

Question: Do these royalties create FPHCI? Answer: No. FPHCI is not created since the royalties are “derived in the active conduct of a trade or business.” See §954(c)(2)(A); Reg. §1.954-2(d).

USM (US)

Matterhorn (Swiss)

Unrelated Supplier IP Licensing

Royalties

68

Problem 1c p. 581 Matterhorn

Matterhorn (Swiss Co.) receives 200,000 of dividends and 100,000 of interest from each of two wholly owned subsidiaries organized in (i) Belgium and (ii) Switzerland. Dividend and interest income normally constitutes FPHCI under §954(c)(1). But, consider the same country related person exception (Swiss) of §954(c)(3)(A)(i) and Section 954(c)(6) for Belgium subsidiary But, consider rule concerning payment is not permitted to reduce Subpart F income.

USM (US)

Swiss Subsidiary

Matterhorn (Swiss)

Belgium Subsidiary

$800 Mfgr Income $200 Passive Interest

$600 Mfgr Income $400 Passive Interest

69

Problem 1d p. 581 Matterhorn

Sales of gold coins having numismatic value purchased for investment. Sale is made to an independent dealer in Switzerland.

Question: Does the sale of these coins create FPHCI? Answer: Yes, this sale does create FPHCI to Matterhorn. The coins are investment in property which “does not give rise to any income”. Thus, the gain on this sale is FPHCI. §954(c)(1)(B)(iii). The gain would not be FPHCI if Matterhorn were a dealer (i.e., the coins were inventory in its hands).

USM (US)

Matterhorn (Swiss)

Unrelated Swiss Dealer Sell Coins

Cash

ü 

70

Problem 1e p. 581 Matterhorn

Sale of all rights to a group of patents to a Swiss corporation. Question: Does the sale of the Swiss patents create FPHCI?

Answer: Yes, the sale of these patents creates FPHCI under §954(c)(1)(B)(i). There is no exclusion for selling patents that were not used in the active trade or business income. This is an odd result given that the royalties would have not created Subpart F income due to the same country related party exception of §954(c)(3)(A)(ii).

USM (US)

Swiss Subsidiary

Matterhorn (Swiss)

Sell S

wiss

Patents

Cash

ü 

71

Problem 1f p. 581 Matterhorn

Purchase of golf balls from USM and sold to an unrelated person outside Switzerland. Question: Does this trading pattern create FBC sales income? Answer: Yes, because a related person is involved in the purchase or sale transactions (Test #1) and the product originated outside Switzerland and is sold for use outside of Switzerland (Test #2). Note that packaging is not manufacturing.

Matterhorn (Swiss) Unrelated

Non-Swiss Distributors Golf Balls

USM (US)

Golf Balls ü 

72

Problem 1g p. 581 Matterhorn

Sale of golf balls to independent distributors in Switzerland (assuming the property is for actual use in Switzerland).

Question: Does this trading pattern create FBC sales income? Answer: No FBC sales income exists here since goods are sold within Switzerland, i.e., no third country is involved (assuming no subterfuge on destination of purchases!). Test #1 met but not Test #2.

Matterhorn (Swiss)

Unrelated Swiss Distributors

Golf Balls

USM (US)

Golf Balls

73

Problem 1h p. 581 Matterhorn

Purchase of golf balls from independent US manufacturer and sold to an unrelated person outside Switzerland

Question: Does this trading pattern create FBC sales income? Answer: No FBC sales income since no related person is involved in the purchase or sale transactions. Test #2 is met, but Test #1 is not met and so there is no FBC sales income.

USM (US)

Matterhorn (Swiss) Golf Balls Unrelated

Non-Swiss Distributors Golf Balls

Unrelated US Mfgr

Commission?

Commission?

74

Problem 1i p. 582 Matterhorn

Manufacture by Matterhorn of golf balls in Switzerland from components purchased from the U.S. parent corporation.

Question: Does this trading pattern create FBC sales income? Answer: No if the Matterhorn activities constitute “manufacturing” that entitles it to the “manufacturing exception” of §954(d)(1), but minor assembly or repackaging is not sufficient to be manufacturing for this purpose. See the Fischbien case in later chapter).

USM (US)

Matterhorn (Swiss)

Unrelated Non-Swiss Distributors

Golf Balls Components

75

Problem 1j p. 582 Matterhorn Contract Manufacturing

Manufacture by contract manufacturer in Switzerland from components purchased from USM.

Question: Does this trading pattern create FBC sales income?

Answer: Probably does create FBC sales income. Matterhorn does not appear to have made a “substantial contribution” with respect to the manufacturing process through the activities of its employees. See Reg. §1.954-3(a)(4)(iv)(a) through (d) and especially Reg. § 1.954-3(a)(iv)(d), Ex. 1. Thus, the sale of the golf balls would constitute FBC sales income under §954(d).

USM (US)

Matterhorn (Swiss)

Unrelated Non-Swiss Distributors

Golf Balls Components

ABC Corp (Swiss)

76

Problem 1k p. 582 Matterhorn Contract Manufacturing

Manufacture by contract manufacturer in Switzerland from components purchased from USM. Matterhorn employees provide product design, quality control, and oversaw manufacturing logistics.

Question: Does this trading pattern create FBC sales income?

Answer: Probably not FBC sales income because Matterhorn makes a “substantial contribution” with respect to the manufacturing process through the activities of its employees thus entitling it to the “manufacturing exception.” See Reg. § 1.954-3(a)(4)(iv)(a)-(d) and especially Reg. §1.954-3(a)(iv)(d), Ex. 2.

USM (US)

Matterhorn (Swiss)

Unrelated Non-Swiss Distributors

Golf Balls Components

ABC Corp (Swiss)

77

Problem 1l p. 582 Matterhorn Definition of “Related”

Matterhorn (1) purchases from (a) USM 49 percent owned German corporation and (b) USM 51 percent owned Dutch corporation and (3) resells outside Switzerland. Issue concerns what is a “related party” for Subpart F purposes – see §954(d)(3) concerning definition of a related party. More than 50% of the vote or value is required. German Co. not related; Dutch Co – yes related.

USM (US)

Matterhorn (Swiss)

Unrelated Non-Swiss Customers

Sell Dutch Co.

(Nethrlands) German Co. (Germany)

49% 51%

Sell

ü 

78

Problem 1m p. 582 Matterhorn Definition of “Related”?

Matterhorn (Swiss Corp.) purchases from a 50 percent owned German corporation.

Question: Does the below trading pattern create FBC sales income? Answer: The German corporation would not be related (to Matterhorn) since it needs to be more than 50% owned by vote or value. See Section 954(d)(3).

USM (US)

Matterhorn (Swiss)

Unrelated Non-Swiss Customers

Sell Dutch Co.

(Nethrlands) German Co. (Germany)

50% 51%

Sell

ü 

79

Problem 1n p. 582 Matterhorn Sales Commission

Matterhorn acts as a sales agent, receiving commission for services, rather than buying and reselling.

Question: Does the below trading pattern create FBC sales income?

Answer: inclusion for commissions from Dutch Co since (in addition to purchase/resale arrangements) the FBC sales income definition contemplates sales commission income but not German Co since not a related party.

USM (US)

Matterhorn (Swiss)

Unrelated Non-Swiss Customers

Commission Dutch Co.

(Nethrlands) German Co. (Germany)

49% 51%

Commission

ü 

80

Problem 1o p. 582 Matterhorn FBC Services Income

Services are rendered by Matterhorn to independent customers outside Switzerland:

Question: Does the below trading pattern create FBC services income? Answer: No. Although services are performed outside of Switzerland where Matterhorn is organized, these services were not performed for a related party. See §954(e).

USM (US)

Matterhorn (Swiss)

Unrelated Non-Swiss Customers

Services

81

Problem 1p p. 582 Matterhorn FBC Services Income

Services are rendered for a related party (brother-sister corp.). See §954(d)(3). Question: Does the below trading pattern create FBC services income?

Answer: No FBC services income. Services are performed in the country (Switzerland) where Matterhorn is organized. Consequently, not FBC services income (the geographic element of the FBC services income test is not met). See §954(e).

81

USM (US)

Matterhorn (Swiss)

Dutch Co. (Netherlands) Services

82

Problem 1q p. 582 Matterhorn De Minimis Rule

Only 4% of the income is FBC Services income and, therefore, all this income is within the protection of the “de minimis” rule (i.e. no FBC income taint).

Question: Does this fact pattern create a subpart F inclusion? Answer: No. The de minimis rule applies. This is a gross income test. See §954(b)(3)(A). Planning: generate large amount of active operation gross income (20 million.) to protect a limited passive income amount (< $1 million.).

USM (US)

Matterhorn (Swiss)

$9.6 Million Mfgr Income $0.4 Million FBC Services Income

83

Problem 1r p. 583 Matterhorn Full Inclusion Rule

75 percent of the Matterhorn income is FBC services income. Question: Does this fact pattern create a subpart F inclusion?

Answer: Yes. All the Matterhorn income (including 25% non-tainted income) is treated as FBC services income under the §954(b)(3)(B) “full inclusion” (more than 70%) rule.

USM (US)

Matterhorn (Swiss)

$7.5 Million FBC Services Income $2.5 Million non-FBC Services Income

ü 

84

Problem 1s p. 583 Matterhorn High Tax Income

Services income is subject to an effective rate of Swiss and other foreign income taxes of 32 percent.

Question: Would there be a subpart F inclusion in this case?

Answer: No subpart F inclusion. Services income is excluded from FBC services income if the proper high-taxed income election is made. The effective tax rate in this problem is greater than 31.5% (90% of 35%).

USM (US)

Matterhorn (Swiss)

$7.5 Million FBC Services Income $2.5 Million non-FBC Services Income

85

Problem 1t p. 583 Matterhorn Partnership Attribution Rule

Matterhorn as a 60% partner in a Belgium partnership and the partnership receives interest income that would be FPHCI if received directly by Matterhorn.

Question: Does USM have a subpart F inclusion? Answer: Issue is whether to make a classification decision concerning the income as if the income is being received directly by the partner? Is an entity or aggregate analysis applicable? See Reg. §1.954-1(g)(1) & Brown case (Tax Court).

USM (US)

Matterhorn (Swiss)

X P/S Interest

ü 

86

Problem 2 p. 583 Factoring Income?

Sale by a U.S. seller to a Swiss sub of installment notes received by the U.S. seller. The price paid is less than the unpaid balance on the obligations. Swiss sub either (1) collects on the obligation or (2) sells it at a profit to an unrelated party.

Question: Does this fact pattern create FPHCI? Answer: Yes. The income (when) realized is related party factoring income and interest. §864(d)(1). And, therefore, FPHCI is received by Sub. See also slide 102 for §956 implications.

USM (US)

Matterhorn (Swiss)

Trade Receivables

ü 

87

Problem 3 p. 583 Loan to Parent’s Customers

Matterhorn loans funds directly to unrelated foreign customers who use the funds to buy USM goods.

Question: Does this trading pattern create FPHCI? Answer: The income on the loan would be interest income and would be FPHC income. §864(d)(6).

USM (US)

Matterhorn (Swiss)

Trade Receivables Unrelated Foreign Customers Export Loan

ü 

88

Problem 4 p. 583 Sale of Good or Service?

Eastlaw (U.S.) online legal research database. Foreign Base Co. (sub) purchases access to database and sells access to unrelated customers in other foreign countries.

Question: Does FBC S.A.’s income represent subpart F income? The issue to resolve is whether the database access a sale of a good so that the FBC sales rules apply or is it a service?

Answer: The income of FBC S.A. is likely subpart F regardless of analysis. 1)  FBC Sales Income: Related party purchase and sale outside of Bermuda. 2)  FBC Services Income: FBC services income if Eastlaw provided “substantial assistance” to FBC S.A.

Eastlaw (US)

FBC S.A. (Bermuda)

Database Access Trade Receivables Unrelated Foreign Customers Database Access

Cash

ü 

89

Problem 5 p. 583 In-Country Services (Sales)?

U.S. Corp. sells computers on Internet. Tax haven sub processes customer orders and arranges delivery into third countries. Tax haven sub receives a fees for its services.

Question: Does this trading pattern create FBC sales income? Answer: Better view is that this is FBC sales income (commission income) for agent sale-side support. If tested under the FBC services income rules, then it would not be FBC services income because the services are rendered in the tax haven; if outside the tax haven, FBC services income. §954(e).

Nile, Inc. (US)

Tax Avoidance Ltd. (N.A.) Logistic Support Trade Receivables

Unrelated Foreign Customers Computers

Cash

ü 

90

Earnings Invested in U.S. Property - §956 p. 584

Concept of deemed repatriation of foreign earnings (any income type – not limited to “tax-haven” type income realized by CFC). For determining this amount “invested in U.S. property” – i.e., the lesser of: 1)  The current year investment, or 2)  The shareholder’s pro rata share of “applicable earnings”.

Limit of the required inclusion is the adjusted tax basis of property acquired (less debt).

US Parent

Foreign Subsidiary

Deferral Privilege Lo

an o

r D

ivid

end?

Cash

91

§956’s Effects: §960(c)’s Limited Anti-Hopscotch Rule p. 586-587

Impacts of §956 Inclusion: 1)  2nd inclusion is avoided if Subpart F inclusion has occurred per §959. 2)  No foreign tax withholding at source on the deemed dividend. US

Parent

S

SS

100%

100%

SSS

100% $100

$140

$180

SSS E&P Taxes $200 $100 <$100> <$ 50>* $100 $ 50 *902 Calc: 100/200*100=50

SS E&P Taxes $180 $120 $100 $ 50 $280 $ 170* <$140> <$ 85> $140 $50 *902 Calc: 140/280*170=85

S E&P Taxes $100 $ 75 $140 $ 85 $240 $ 160* <$180> <$ 120> $ 60 $ 40 *902 Calc: 180/240*160=120

Review of Problem 4 on page 396

§956 Loan

3)  §960(c) limits the FTC availability to the lesser of the tentative credit allowed by a straight application of §956 or the hypothetical credit that would have occurred if there had been an actual dividend through the chain. §960(c) calculation:

a.  “Tentative FTC” is $50. b.  Hypothetical Credit is $67

(100/240 * 160).

92

Defining Investment in “U.S. Property” p. 587

1)  Tangible property located in the United States - §956(c)(1)(A).

2)  Stock of a U.S. corporation, if related (25% ownership connection). §956(c)(1)(B).

3)  Debt obligations of related U.S. persons. §956(c)(1)(C) (as of end of each Quarter).

4)  Rights to use U.S. patents, know-how, copyrights or similar U.S. use property.

93

Exclusions from “United States Property” §956(c)(2)

Examples: 1)  U.S. Treasury obligations and bank

deposits – but consider The Limited 6th Cir. (p. 533) where CFC purchased CDs from related (credit card) internal related-party bank. Held: bank deposit exception applied. But, see §956(c)(2)(A) (2004), as revised, re a “real bank”.

$174 million

CDs

SP (US)

WFNNB (US)

MFE (Far East)

MFE (NV)

2)  Export Property (if customary in amount)

3)  Stock issued by an unrelated corporation.

4)  Transportation equipment outside U.S.

94

Short-Term Loans to Related Party

Certain short-term loans disregarded. Notice 88-108’s “30-60” obligation. Temporary Exceptions for Financial Crisis:

1.  Notice 2008-91: “60-180” obligation. Repay loan with 59 days and total loan days cannot exceed 180 days. Two year rule.

2.  Notice 2009-10: extend to 3 years availability. 3.  Notice 2010-12: rule applies through 2010.

Anti-abuse Rules: 1.  Back-to-back loans through

conduit. See Rev. Rul. 87-89 2.  A series of short-term loans

might be integrated for §956 purposes. See Rev. Rul. 89-73

3.  Dropping cash into CFC sub to make loan and sub has no E&P.

US Parent

Foreign Subsidiary

Intermediary

Break-Even Co (Swiss)

USM (US)

Loan Dutch Co.

(Nethrlands)

Loan

Loan

Deposit

1

3

ü  ü 

95

Loans to Related Party Merck v. U.S. (a.k.a. Schering Plough)

FACTS: Schering Plough entered into swap on notional $650 million where it paid LIBOR and received Fed Funds. Schering-Plough assigned its right to receive Fed Funds on $650 million to Scherico for $460 million.

Issue: Was Scherico’s payment of $460 million to Schering Plough sales proceeds for the sale & assignment of the contractual right to receive Fed Funds on notional amount of $650 million (to which Rev. Rul. 89-73 set forth treatment) or was this a $460 million “loan.” Holding: Third Circuit said that the substance of the transaction was a loan and refused to respect the separate assignment leg as a separate and distinct transaction that was a sale of a contractual right.

Schering-Plough (US)

Scherico (Switzerland)

ABN

1991 Transaction

Fed Funds 2

1

96

Pledges & Guarantees p. 590 Indirect Repatriations

See §956(d) concerning deemed repatriations re pledges and guarantees. Possible alternative situations: 1)  CFC guarantees the financial obligation of the U.S. corp.

2)  U.S. corporation pledges the stock of the CFC to secure financing.

97

Ludwig Case p. 590 Pledging Stock of CFC

FACTS: Stock of CFC (Oceanic, a Panamanian corporation) pledged by Ludwig as collateral for a loan to enable Union Oil stock acquisition by Ludwig.

Oceanic (Panama) Union Oil

Company

Phillips Petroleum Company Ludwig Pledge of 100%

Oceanic Stock

Holding: CFC (Oceanic) was not a guarantor of Ludwig’s obligation. No undertakings by CFC. Remedy is a sale of the pledged stock (not Oceanic liquidation).

98

Sequels to the Ludwig Case p. 599

Reg. §1.956-2(c)(2) concerning indirect pledges: If the assets of a controlled foreign corporation serve at any time, even though indirectly, as security for the performance of an obligation of a United States person, then, for purposes of paragraph (c)(1) of this section, the controlled foreign corporation will be considered a pledgor or guarantor of that obligation. For this purpose the pledge of stock of a controlled foreign corporation will be considered as the indirect pledge of the assets of the corporation if at least 66 2/3 percent of the total combined voting power of all classes of stock entitled to vote is pledged and if the pledge of stock is accompanied by one or more negative covenants or similar restrictions on the shareholder effectively limiting the corporation’s discretion with respect to the disposition of assets and the incurrence of liabilities other than in the ordinary course of business f business.

Why a 66 2/3% requirement (and negative covenants)?

What authority for IRS to promulgate this §956 regulation?

What if two loans with pledges of 35% and 65% of stock of the CFC to two lenders?

99

Indirect Ownership of U.S. Property (Through Partnership)

Rev. Rul. 90-112 p. 601 CFC is a minority partner in foreign partnership owning real property in U.S. The partnership is foreign country based and invests in US land. Code §956(c)(1) includes this U.S real property (indirectly owned) within the concept of U.S. property. Use of an “aggregate” partnership approach deemed appropriate.

P (US)

S (Country X)

PRS (Country X)

US Land

ü 

100

What About Pledge of a U.S. LLC Interest?

Assume (1) U.S. parent corp. pledges its interest in a U.S. LLC and (2) U.S. LLC itself owns stock in a CFC (and an interest in a U.S. business). Should the LLC be treated as disregarded for applicability of §956? Probably.

101

Further §956 Questions Re Pledges

1)  What if pledge of asset worth less than amount of loan? Inclusion to amount of loan or lesser value of asset?

2)  Guarantee by CFC, but value of CFC is less than the loan?

3)  Pledge of partnership interest when partnership holds CFC stock?

4)  Loan by CFC to foreign partnership owner where U.S. partner holds majority/minority interest in the partnership?

102

Problem 1 p. 602 Delft, N.V., a CFC

Dutch corporation owned by U.S. corp.; Dutch corp. engaged in manufacturing. Assume no FBC income. Dutch corp.’s surplus earnings are: 1.  Loaned to U.S parent

corporation(over Quarter end). Loan to a related person is treated as an investment in U.S. property under §951(a)(1)(B) and §956.

2.  Used to purchase stock of unrelated NYSE listed company. Not an investment in US property.

3.  Used to purchase U.S. patent for license to unrelated US person is an investment in US property.

Eurotile, Inc. (US)

Delft (Nethrlands)

1

Loan

Eurotile, Inc. (US)

Delft (Nethrlands)

2

Loan

Eurotile, Inc. (US)

Delft (Nethrlands)

3

Loan License Unrelated US Licensor

Invest Stock of Unrelated Company

ü 

ü 

103

Problem 2 p. 603 Sale or Loan to CFC

1)  Sale by USM to Matterhorn of installment notes. The price paid is less than the unpaid balance on the obligations. Amounts paid by Matterhorn from its earnings to USM is an investment in U.S. property to the extent of the U.S. obligations. §956(c)(3) and §864(d).

2)  Loan to unrelated foreign customers of USM is not an investment in U.S. property since not acquiring a trade or business receivable from a related U.S. person. §956(c)(3)(A).

USM (US)

Matterhorn (Swiss)

Trade Receivables

USM (US)

Matterhorn (Swiss)

Trade Receivables Unrelated Foreign Customers Export Loan

1

2

ü  Problem 2 on p. 583

Problem 3 on p. 583

104

Previously Taxed Income and Ordering Rules p. 603

Three levels of possible income recognition: 1)  Subpart F

2)  §956 – investment in U.S. property

3)  Actual dividend distribution See §959(c) re order of distributions (§956 income first, then Subpart F income)

If previously taxed, nontaxable distributions not carrying out foreign tax credits.

105

Previously Taxed Income and Ordering Rules, Continued

Consider an upstream dividend from a 2nd tier subsidiary (CFC) to a first tier subsidiary (CFC). Subpart F (FPHC) income to first tier subsidiary? Yes, unless previously included in shareholder income under §951(a). See §951(a). See §959(b). p. 604.

USM (US)

Swiss Subsidiary

Matterhorn (Swiss)

Belgium Subsidiary

$800 Mfgr Income $300 Passive Interest (not $100)

$600 Mfgr Income $400 Passive Interest

Revised Matterhorn Problem 1c (page 581)

106

Treatment of Stock Sale p. 605 Gain as Ordinary Income

General Rule of §1248: Gain realized on the disposition of the CFC stock investment is (recast) as dividend income.

1.  §1248 Result: Transforms capital gain into a “deemed” dividend distribution to the extent of 10% shareholder’s allocable E&P, limited to amount of stock gain.

2.  Implication: Is §1248 treatment preferred? Yes, for a corporate shareholder, since the deemed paid FTC is available. Reg. §1.1248-1(d).

3.  Foreign Tax Advantage: Generally there is no foreign withholding tax on a stock sale (rather than if an actual dividend distribution).

4.  Individuals: Can avoid §1248 by holding CFC stock until death.

Buyer

Gain of $200 What about the §1248 Amount?

US Parent

Foreign Subsidiary

Deferral Privilege

Cash

Untaxed E&P Pool $100 Tax Pool $10

107

Treatment of Stock Sale Gain as Deemed Dividend

§1248(b) limits the tax attributable to the deemed dividend. Deemed dividend under §1248 does not reduce the CFC’s E&P. §959(e) treats §1248 deemed dividend as previously taxed E&P and, therefore, not subject to tax on a later distribution. E&P reduced when a subsequent nontaxable distribution is actually made. §959(e).

US Buyer

§1248 Amount

US Parent

CFC (Switzerland)

Cash

E&P Pool Tax Pool

US Buyer

Foreign Subsidiary

PTI

1 Step One: Sell CFC to Buyer

2 Step Two: CFC distributes dividend to Buyer

PTI

108

Previously Taxed Income and Ordering Rules

Consider (1) a sale of CFC stock and (2) CFC income previously included as Subpart F income in seller’s income or includible under §956. Inclusion in gross income again? No, §959(a).

109

Treatment of Stock Sale Gain as Deemed Dividend at CFC Level

§964(e) recasts gain as dividend to the extent of CFC #2 earnings and profits. The dividend carries §902 credits. Section 964(e) applies policy of §1248 to the CFC level.

US Buyer

§964(e) Amount

US Parent

CFC (Switzerland)

Cash

1 Step One: Sell CFC to Buyer

CFC #2 (UK)

110

Problem - §1248 p. 608 Corp. Partial Stock Sale

Heavy Metals Consequences: 1.  The sale of 20% interest in FC for $300,000 (cost basis is $14,000 + $36,000 basis increase

from prior Subpart F inclusion) provides $250,000 gain of which only $70,000 is reported as long-term capital gain ($250,000 - $180,000).

2.  Ordinary Dividend is $180,000 (20% of $900,000) per §1248. 3.  §78 Gross-Up of $20,000 (20% of $100,000). 4.  So, total income inclusion is $270,000 ($70,000 + $180,000 + $20,0000). 5.  §902 Deemed Paid Credits: $20,000 Mary 1.  The sale of 20% interest in FC for $300,000 (cost basis is $14,000 + $36,000 from prior

Subpart F inclusion) provides $250,000 gain of which only $70,000 is reported as long-term capital gain.

2.  Mary could elect to apply §962 to obtain §78 Gross-Up and Deemed Paid Credits.

Heavy Metals (US)

Foreign Base Co (Switzerland)

$300x

Untaxed E&P Pool $900,000 / $180,000 = 20% Tax Pool $100,000 / $20,000 – 20% PTI $180,000 / $36,000 = 20%

Mary sells all 20% and Heavy Metals sells 20% of its interest in Foreign Base Co

Mary 20% Buyer

20% 80%

$300x

20% Buyer

111

Sale or Exchange of a Patent to a CFC p. 610

§1249 transforms capital gain into ordinary income when a patent is sold to a foreign corporation by a U.S. transferor which owns more than 50% of the voting power of the purchaser foreign corporation. To preclude capital gains sales to CFC which then sublicenses (receiving ordinary, deferred income; but FPHC income?). Cf., §367(d) re contribution of intangibles to foreign corporation. Note: §174 re prior R&D deduction.

112

PFIC – Passive Foreign Investment Co. p. 611

PFIC provisions - §§1291-1298

Applicable to all U.S. persons.

Choices of taxation for U.S. shareholders:

1)  Election for current inclusion (QEF)-- §1293. Exception: Can elect to defer US tax on amounts not currently distributed, but the cost of this election is an interest charge on the deferred tax-- §1294.

2)  Mark to market election (current income)-- §1296

3)  Not QEF – tax on (i) distribution from the QEF (plus interest charge) or (ii) sale of shares (plus interest)-- §1291(a).

PFIC (Cayman)

US Person

0.1%

Passive Income Test or Passive Asset Test

113

Definition of a PFIC p. 612

PFIC Test: (i)  75% of Corp.’s gross income is passive income (an income test, i.e., income that would be foreign personal holding company income) or

(ii)  50% of assets are held for the production of passive income (the asset test, based on value, subject to election – except for public company – to use tax basis; plus mandatory requirement for non-public CFCs to use tax basis). §1297(a). Year-by-year test.

PFIC (Cayman)

US Person

0.1%

Passive Income Test or Passive Asset Test

114

Special PFIC Status Rules p. 614

PFIC Test: Leased properties treated as assets held by PFIC – as part of the active business assets. §1298(d). p. 613 Active banking business exception. §1297(b)(2)(A) p. 613 Interest, dividend, rent and royalty from a related person exception (sourced from business income). §1297(b)(2)(C). p.613

PFIC (Cayman)

US Person

0.1%

Passive Income Test or Passive Asset Test

115

Look-Through Rule p. 615

PFIC Test: Look through rule for 25 percent or more owned subsidiaries - §1297(c). Purpose: To prevent foreign corps having active subs from being treated as PFICs. Dividends and interest received from this subsidiary are eliminated from income for purposes of the income test. Stock of this subsidiary is eliminated for purposes of the asset test. §1297(c).

PFIC (Cayman)

US Person

0.1%

Passive Income Test or Passive Asset Test

116

The Starting or Changing Business Rules p. 616

PFIC Test: Special rules apply for: 1)  The start-up year for an active

business operation, §1298(b)(2), and

2)  Corporations changing active businesses. Corporation not treated as a PFIC. §1298(b)(3).

PFIC (Cayman)

US Person

0.1%

Passive Income Test or Passive Asset Test

117

Subpart F – PFIC Overlap p. 617

PFIC / Subart F Overlap: If both PFIC and Subpart F would apply, then the Subpart F rules take priority. §1297(d). This enables deferral without an interest charge accruing (for non-Subpart F income). Non “U.S. shareholders” (e.g., less than 10% ownership) are subject to the PFIC rules.

For Co (Cayman)

US Shareholder

≥ 50%

Passive Income Test or Passive Asset Test

Subpart F Trumps PFIC

US Person

0.1% PFIC Applies

118

Excess Distribution from or Disposition of PFIC p. 618

If not a QEF, an interest charge is imposed on the value of the tax deferral at the time: 1)  Of the disposition of PFIC stock at

a gain, or 2)  The receipt of an “excess

distribution” from the PFIC (i.e., above 125% of prior dividend distribution level).

§1291(a)(1) & (2). PFIC distribution to U.S. corp. enables deemed paid FTC. See §1291(g).

PFIC (Cayman)

US Person

0.1%

Passive Income Test or Passive Asset Test

Exc

ess

D

istr

ibut

ion

119

Qualified Electing Fund (QEF) p. 620

Election by each shareholder - not by the PFIC.

Information to come from the corporation. Current inclusion in gross income of the shareholder’s prorata share of the PFIC’s earnings and profits. §1293. Can divide into the prorata shares of fund’s: (i)  Net capital gains, and (ii)  Ordinary income. §1293(a)(1).

120

QEF & Tax Deferral When No Distribution p. 622

§1294 does permit the PFIC – QEF election shareholder to elect to defer the tax amount if no actual distribution has occurred. No deferral if §951 applies. Deferral is subject to an interest charge. Loan to a shareholder is treated as a distribution. §1294(f).

121

Mark-to-Market Election p. 622

Available for “marketable stock” of PFIC. §1296 – U.S. shareholder includes in (ordinary) income the excess of fair market value of the PFIC stock at close of year over basis (as previously adjusted). Treated as ordinary income. What if loss? Permitted to the extent of the “unreversed inclusions”. Treated as ordinary loss. §1296(a)(2).

122

Problem 1 p. 626 PFIC & CFC Comparison

PFIC provisions apply even if no CFC status. Apply even to less than 10 percent ownership by U.S. shareholder in PFIC. CFC provisions of Subpart F apply to more income types. PFIC only applies to passive income. PFIC ends benefits of deferral for all income of the PFIC, not limited to specified types of gross income. PFIC has a more complete termination of deferral of income recognition.

123

Problem 2a p. 627 CFC Status?

Tax Avoidance is a CFC under §957(a): Two “United States shareholders” holding more than 50%: U.S. parent owns 40 shares and Sam (U.S. citizen) owns 12 shares; no attribution to Sam from NRA sister - §958(b)(1).

US Parent

Tax Avoidance

40

Sam Angelina

12 15

Wolfgang

9

Foreign Venture

Alexander 50%

Foreign Business, Inc.

USA, Inc.

5 18

John

1

50%

100 Shares in Total

Passive Income Test or Passive Asset Test

124

Problem 2b p. 627 PFIC Status?

Tax Avoidance is a PFIC under §1297(a): Meets the 50% passive assets test (based on tax basis ratios). §1297(a)(2) & §1297(f)(2)(A).

US Parent

Tax Avoidance

40

Sam Angelina

12 15

Wolfgang

9

Foreign Venture

Alexander 50%

Foreign Business, Inc.

USA, Inc.

5 18

John

1

50%

100 Shares in Total

Passive Income Test or Passive Asset Test

125

Problem 2c p. 627 CFC Income?

1.  U.S. shareholders are U.S. Parent (40%) and Sam (20%). 2.  US Parent and Sam have constructive dividends for pro rata shares of Tax Avoidance’s $6.5 million Subpart F income: (i) $5.5 million dividends and capital gains (§954(c)(A) & (B)) and (ii) $1 million FBC sales income (§954(d)).

US Parent

Tax Avoidance

40

Sam Angelina

12 15

Wolfgang

9

Foreign Venture

Alexander 50%

Foreign Business, Inc.

USA, Inc.

5 18

John

1

50% ü 

126

Problem 2d p. 627 PFIC Applicability

1.  PFIC provisions apply without regard to the amount of ownership. But, not treated as a PFIC for those persons treated as U.S. shareholders of a CFC. §1297(e). This is applicable to U.S. Parent & Sam.

2.  Alexandra (indirect ownership), (ii) USA, Inc., and (iii) John are subject to the PFIC rules. Options for them: interest charge or QEF. No “mark-to-market” option.

US Parent

Tax Avoidance

40

Sam Angelina

12 15

Wolfgang

9

Foreign Venture

Alexander 50%

Foreign Business, Inc.

USA, Inc.

5 18

John

1

50%

ü  ü  ü 

127

Problem 2e p. 627 Regularly Traded Stock

1.  Stock would constitute “marketable stock” within the meaning of §1296(e).

2.  Those shareholders subject to the PFIC rules could make the “mark to market” election under §1296.

US Parent

Tax Avoidance

40

Sam Angelina

12 15

Wolfgang

9

Foreign Venture

Alexander 50%

Foreign Business, Inc.

USA, Inc.

5 18

John

1

50%

ü  ü  ü 

128

Reporting Requirements p. 628

Information returns (IRS Form 5471): §6046 – information of formation of the foreign corporation. §6038 – annual information by every person who is in control of a foreign corporation.

129

Summary p. 632 Policy Options

Options for Foreign Income Taxation: 1)  Current Full Inclusion

2)  Subpart F Structure

3)  Foreign corporation dividend exemption.

See: House Ways & Means draft of Tax Reform Act of 2014 (February 26, 2014) Senate Finance Committee Discussion Draft of Provisions to Reform International Business Taxation (Nov. 19, 2013) House Ways & Means Discussion Draft of Tax Reform Act of 2011 (Oct. 26, 2011) JCT 2005 Options Paper Bush 2005 Tax Panel Recommendations 2000 U.S. Treasury Study

130

Problem – U.S. Cleanliness and Camclean Foreign Sub. p. 61

Issues: A)  Right of the U.S. to tax under

international law? B)  What basis for the exercise of

tax jurisdiction by the IRS?

C)  Taxability in the United States?

D) If taxability, then how: on (i) a gross withholding basis or (ii) a net income basis?

US Cleanliness Parent

Camclean Compania

Loan US

Borrower

US Licensor

US Portfolio Investment

Camclean earns: 1.  US Interest (portfolio interest?) 2.  US Royalties 3.  US Dividends 4.  Capital Gains on US stock 5.  Gains from sale of US IP 6.  Service Income in Compania 7.  Dividends from US subsidiary 8.  Service Income from US branch

US Trade or Business

US Cleanliness Subsidiary

Dividend

1

2&5

3&4

6

78


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