iAccording to recent statistics, immigrants and their U.S.-born children now number approximately 84.3 million people, or 27% of the overall U.S. population. The countries from which the largest numbers of these individuals originate include India, China, Mexico, and Canada. Many of those moving to the United States are wealthy business owners who will continue to own interests in, and receive distributions from, non-U.S. businesses after they become U.S. taxpayers.
Many times U.S. tax advisors that engage in pre-immigration planning for such individuals and their respective companies recommend strategies such as “check-the-box” planning to obtain a basis “step-up” in the shares or assets of the underlying non-U.S. companies, acceleration of income recognition, and deferral of loss recognition prior to U.S. residency beginning. One potential strategy that may provide substantial tax benefits is the use of a U.S. partnership to create a “previously taxed income” account prior to the time that a non-U.S. owner of a foreign business becomes a U.S. tax resident.
CFC Rules, in General
A “U.S. shareholder” of a controlled foreign corporation (CFC) is required to include in its gross income a pro rata share of a CFC’s “subpart F” income and amounts included under Section 956, regardless of whether any income actually is distributed. In general, a CFC is a foreign corporation that is more than 50 percent owned (directly, indirectly, or constructively) by “U.S. shareholders.”[1] Subpart F income includes most forms of passive income (e.g., interest, dividends, royalties, capital gains, etc.), as well as income from related party sales and service transactions that have little, if any, connection with the CFC’s country of incorporation.[2] Section 956 inclusions generally consist of many types of investments in U.S. assets made by a CFC, as well as guarantees or pledges (of assets or shares) by a CFC of related U.S. party obligations.[3]
Under Sections 951(b), 957(c) and 7701(a)(4), a U.S. partnership (including a U.S. LLC taxed as a partnership) is treated as a “U.S. shareholder” for purposes of the CFC rules, even if all of its partners are foreign persons that are not subject to U.S. federal income tax. The IRS has acknowledged this position. In fact, the IRS has indicated on more than one occasion that no consideration has ever been given to requiring a foreign person to include in its income any portion of subpart F income passing through a U.S. partnership.[4]
Previously Taxed Income and Basis Adjustments
Section 959(a) provides that the earnings and profits of a CFC attributable to amounts included in the gross income of a U.S. shareholder, otherwise known as “previously taxed income” or “PTI,” shall not, when those amounts are later distributed to a U.S. shareholder, directly or indirectly through a chain of ownership described in Section 958(a), be again included in the gross income of such U.S. shareholder. Distributions made by a CFC are considered to come first from PTI to the extent thereof.[5] Because a U.S. partnership is considered to be a U.S. shareholder for purpose of the CFC rules, if a U.S. partnership includes in its gross income the earnings and profits of a CFC (i.e., Subpart F income or a Section 956 inclusion), the inclusion of the income creates PTI, even though none of the income may be subject to U.S. federal income tax.
Section 961 provides rules for adjusting the basis of shares in a CFC that correspond with the PTI rules under Section 959. Section 961(a) provides for an increase in basis when a U.S. shareholder has a Subpart F inclusion, while Section 961(b) provides for a decrease in basis when the shareholder receives an amount that is excluded from gross income under Section 959(a).
The above treatment of a U.S. partnership (which itself is not subject to U.S. tax) as a U.S. shareholder for Subpart F purposes, coupled with the fact that PTI is defined by reference to income included, rather than income actually subject to tax, gives rise to a significant tax planning opportunity; namely, the ability of a U.S. shareholder to receive tax-free distributions of corporate earnings and profits that have never been subject to U.S federal income tax. While at first glance the creation of PTI by the simple interposition of a U.S. partnership may seem too good to be true, the treatment of a U.S. partnership as a U.S. shareholder for subpart F purposes also may work in the IRS’s favor, by allowing the IRS to tax under the CFC rules income of a foreign corporation that it otherwise would not have the ability to tax.
For example, in PLR 200943004,[6] two foreign corporations and a foreign partnership (which had a mixture of U.S. and non-U.S. owners) jointly owned a U.S. partnership. The U.S. partnership in turn wholly-owned a foreign corporation (“FC”) that was expected to earn passive income. No U.S. person owned, directly or indirectly, 10 percent or more of the voting stock of FC. Therefore, disregarding the U.S. partnership, FC would not have been a CFC. The IRS ruled that because the U.S. partnership was a U.S. shareholder for subpart F purposes, FC was a CFC and the U.S. partnership realized Subpart F income that would be taxable to the U.S. partners. This was the result despite the fact that, had such U.S. persons invested directly in FC, they would not have realized any Subpart F income as none of them owned at least 10 percent of FC’s voting shares. Thus, this ruling demonstrates that, depending upon the facts of a particular situation, the treatment of a U.S. partnership as a U.S. shareholder for subpart F purposes can work either for or against U.S. taxpayers.
Notice 2010-41
In extremely limited circumstances, the IRS takes the position that a U.S. partnership is not to be treated as a U.S. shareholder for subpart F purposes. More precisely, in Notice 2009-7, the IRS identified a transaction of interest labeled the “Subpart F income partnership blocker.” In this transaction, a U.S. taxpayer wholly owns CFC1 and CFC2. The two CFCs are partners in a domestic partnership, USP. USP in turn owns 100% of the stock of CFC3. Some or all of the income of CFC3 is Subpart F income. As part of the transaction, the U.S. taxpayer takes the position that the Subpart F income of CFC3 is currently included in the income of USP (which is a pass-through entity and is not subject to U.S. federal income tax) and therefore is not included in the U.S. taxpayer’s income.[7] In other words, the Subpart F income that passes through to CFC1 and CFC2 under Section 702(b) of the partnership rules has no U.S. federal income tax consequences because only U.S. shareholders are subject to tax under the Subpart F regime. The result of this treatment is that income that otherwise would be taxable currently to the U.S. taxpayer under Subpart F is not taxable at all because of the interposition of a U.S. partnership in the structure.
The 2009 notice was then followed with Notice 2010-41, which announced an intention to issue regulations which would treat domestic partnerships as foreign partnerships for the sole purpose of identifying the U.S. shareholders of a CFC that are required to include in gross income the amounts specified in Section 951(a). These regulations would have no impact on a CFC owned by a U.S. partnership that ultimately is owned by non-U.S. persons.
Planning Opportunities Using PTI in the Pre-Immigration Context
As noted above, non-U.S. persons owning operating businesses abroad often relocate to the United States for a variety of non-tax reasons while continuing to maintain an ownership interest in, and receive distributions from, those foreign businesses. While typical pre-immigration tax advice might involve check-the-box planning (assuming the entity in question is not a “per se” corporation) to obtain a “step-up” in basis of the shares and/or the underlying assets, such planning also has the effect of causing the U.S. taxpayer to be subject to current U.S. federal income tax on all future income of the foreign operating business, even if the income is not distributed. For this reason, unless the business is located in a high-tax jurisdiction (thus increasing the significance of obtaining a foreign tax credit in a flow-through structure), it generally is not beneficial to “check-the-box” on operating entities. This is especially true with respect to businesses operating in a low or zero-tax environment.
This is where the potential use of a US partnership to create PTI may be of value. Assume two Canadian residents own a Canadian holding company (“Holdco”) that is a “per se” entity under the check-the-box rules. Holdco in turn owns minority interests in a number of companies operating in free trade zones in Costa Rica, Panama, and Uruguay (the “Opcos”). The Opcos are exempt from corporate income tax in their home countries. Some of the Opcos are “per se” entities for purposes of the “check-the-box” rules, and some are not. The Canadian residents plan to relocate to the United States in the near future and will continue to own these assets subsequent to the move.
A distribution of the operating profits made to the Canadian shareholders would be taxable in Canada. The Canadian residents thus might consider forming a US partnership and transferring their interests in Holdco to the partnership. This transfer causes Holdco to be characterized as a CFC for US federal income tax purposes. The shareholders could then file check-the-box elections to treat the non-per se Opcos as partnerships for US federal tax purposes. This election should cause Holdco to realize Subpart F income on the deemed liquidation of the relevant Opcos that is included in the gross income of the US partnership.[8] This also creates PTI in the same amount.[9] Once the Canadian residents become US taxpayers, they should then be exempt from US federal income tax on distributions made by Holdco through the US partnership to the extent of such PTI.[10]
Assume alternatively that residents of Spain own 100 percent of the shares of a Spanish ETVE that in turn owns 100 percent of five operating companies located in jurisdictions throughout Europe, Asia, and Latin America. The operating companies are consistently profitable and each one generates a large pool of current year earnings and profits. The Spanish owners plan to relocate to the United States in the future and will continue to hold these investments after the move. In advance of the move, the owners might consider forming a U.S. partnership and transferring their interests in the ETVE to such partnership.[11] This will cause the ETVE to be characterized as a CFC for U.S. federal income tax purposes. The underlying operating companies also will become CFCs.
Assume the U.S. partnership then takes out a $20 million bank loan to fund the business operations of the subsidiary entities. Assume that each of the five operating companies guarantees the bank loan in full. Because the guarantors are CFCs for U.S. federal income tax purposes and the primary borrower is a related U.S. person, these guarantees should trigger an income inclusion to the U.S. partnership under Section 956. This income inclusion in turn should give rise to PTI in the same amount. Assuming that each guarantor has at least $20 million of current year earnings and profits, $100 million of PTI should be created by this transaction.[12] Thus, once the Spanish owners relocate to the United States, it appears that they would be entitled to take $100 million of tax-free distributions from the underlying CFCs through the U.S. partnership.[13]
Possible IRS Challenges
The simple interposition of a U.S. partnership in a completely non-U.S. structure to create the potential for tax-free distribution of income where no U.S. tax has been imposed admittedly seems illogical. Nevertheless, based on the clear language of the statute as well as existing published guidance in this area, this does appear to be the correct result under current law.
If the IRS were to challenge the use of U.S. partnerships in these situations, the most likely basis would seem to be an attack under the partnership anti-abuse rules. Interestingly, however, in Notice 2010-41 the IRS decided against using the anti-abuse provisions in a similar context, instead choosing to treat the U.S. partnership as a foreign partnership to prevent the purported abuse. This may be because the partnership anti-abuse rules themselves contain an example that approves the interposition of a U.S. partnership between the shareholders and a foreign corporation for the sole purpose of converting the foreign corporation into a CFC, which would allow the shareholders to take advantage of more favorable foreign tax credit provisions.[14]
Other possible avenues of attack include the use of common law doctrines, such as substance over form, sham transaction, and economic substance. Those arguments, however, typically are much more difficult to sustain and are used only as a last resort.
[1] Section 951(a). For this purpose, a “U.S. shareholder” is a U.S. person that owns (directly, indirectly, or constructively) 10 percent or more of a CFC’s voting stock. Section 951(b). All Section references are to the Internal Revenue Code of 1986, as amended (the “Code”), and the Treasury Regulations promulgated under the Code.
[2] Section 952(a).
[3] Sections 956(c) and (d).
[4] See 1995 FSA Lexis 496 (March 17, 1995) and 1995 FSA Lexis 131 (March 17, 1995).
[5] Section 951(c).
[6] See https://www.irs.gov/pub/irs-wd/0943004.pdf
[7] Subpart F income is only included in the income of the direct or indirect U.S. shareholder, which is USP. Sections 951(a) and 958(a).
[8] If the CFC is located in a high tax jurisdiction (i.e., a jurisdiction where the corporate income tax rate is greater than 31.5 percent (90 percent of the highest U.S. corporate income tax rate)), any subpart F income that is generated should still create PTI as long as the taxpayer does not elect to apply the so-called “high-tax exception” to subpart F income. This is because a taxpayer needs to make an affirmative election in order to exclude subpart F income under this exception. See Section 954(b)(4).
[9] The U.S. partnership is not required to withhold tax on any subpart F income allocated to the foreign partners. See 1995 FSA Lexis 496 (March 17, 1995) and 1995 FSA Lexis 131 (March 17, 1995).
[10] The U.S. partnership also would have the ability to sell the shares of the CFC without triggering U.S. federal income tax as a result of the basis increase provided by Section 961(a). Of course, if prior distributions of PTI have been made, those distributions would cause a reduction in basis of the CFC stock owned by the partnership under Section 961(b).
[11] Local tax advice should of course be sought with respect to any potential non-U.S. tax issues.
[12] The IRS has taken this position with respect to taxable Section 956 inclusions. See, e.g., FSA 200216022, (https://www.irs.gov/pub/irs-wd/0216022.pdf), in which the IRS argued that multiple guarantees by more than one CFC of the same US obligation could result in a Section 956 inclusion that exceeds the principal amount of the loan. The preamble to the proposed Section 956 regulations issued in 2015 indicates that the IRS was aware of this issue and was considering potential methods of addressing it. The final Section 956 regulations issued in November 2016, however, did not address the issue. Therefore, in the absence of further guidance, it appears that multiple guarantees by more than one CFC of a single US obligation will result in a Section 956 inclusion that exceeds the principal amount of such obligation.
[13] The U.S. partnership in this example should also obtain a $100 million basis increase in its CFC shares as a result of Section 961(a). Any distributions of PTI will cause a corresponding reduction in basis of the CFC stock owned by the partnership under Section 961(b).
[14] Regulation Section 1.701-2(f), example 3.
