Anti-Deferral Regimes: U.S. Taxation of Foreign Corporations

Read Publication

When a U.S. business expands abroad, it is frequently believed that the income of foreign subsidiary corporations will not be taxed in the U.S. until dividends are distributed to the U.S. shareholder. This is known as tax deferral, which is the general expectation of clients. However, in the U.S., tax deferral may be overridden by provisions accelerating the imposition of U.S. tax on U.S. shareholders of foreign corporations. As a result, income may be taxed before a dividend is distributed. This article describes the anti-deferral provisions of U.S. tax law that may be applicable in certain situations.

ANTI-DEFERRAL REGIMES

The Internal Revenue Code contains two principal anti-deferral regimes that may impose tax on a U.S. taxpayer on a current basis when its foreign subsidiaries generate income. These provisions reflect a policy under which Congress believes the deferral rules are being abused to inappropriately defer U.S. tax, especially if foreign tax is not imposed for one reason or another. The two regimes are the:

• Controlled Foreign Corporation (“C.F.C.”) regime under Code §§951-964, also known as the “Subpart F” provisions; and
• Passive Foreign Investment Company (“P.F.I.C.”) regime under Code §§1291-1298.

Controlled Foreign Corporations

Under Code §957(a), a foreign corporation is a C.F.C. if stock representing more than 50% of either the total combined voting power or the total value of shares is owned, directly, indirectly, or by attribution, by “U.S. Shareholders” on any day during the foreign corporation’s taxable year. With respect to a foreign corporation, a U.S. Shareholder is defined as a “U.S. person” that owns, under the foregoing expanded ownership rules, stock representing 10% or more of the total voting power of all classes of the foreign corporation’s stock that is entitled to vote. A “U.S. person” includes a U.S. citizen or resident, a U.S. corporation, a U.S. partnership, a domestic trust, and a domestic estate. Stock ownership includes indirect and constructive ownership under the rules of Code §958. Consequently, ownership can be attributed, inter alia, from foreign corporations to shareholders, from one family member to another, and from trusts and estates to beneficiaries, legatees, and heirs.

Insights Vol. 1 No. 4: Updates & Other Tidbits

Read Publication

PASSIVE FOREIGN INVESTMENT COMPANY: RELAXATION OF RULES APPLICABLE TO TAX-EXEMPT SHAREHOLDERS

The passive foreign investment company (“P.F.I.C.”) rules can have an adverse impact on any U.S. person that may invest in a foreign company classified as a P.F.I.C. A P.F.I.C. can include an investment in an offshore investment company that owns investment assets such as stocks and securities. While ownership by a taxable U.S. investor can produce adverse tax results, ownership by a U.S. taxexempt entity, such as a retirement plan or an individual retirement account (“I.R.A.”), usually will not result in adverse tax results. This situation is helpful since many tax-exempt entities invest in offshore investment companies. The one exception is if the U.S. tax-exempt investor borrows money to make its investment in the P.F.I.C. then the U.S. tax exempt may recognize unrelated business taxable income (“U.B.T.I.”) from this investment. Despite its tax-exempt status, U.B.T.I. is taxable to a U.S. tax-exempt investor under Code §511.

The P.F.I.C. rules, as do many tax rules, include extensive constructive ownership rules whose purpose is to make sure that the statutory purpose behind the rules are not undercut by use of intermediate holding companies or other means. One lurking issue was whether these constructive ownership rules could possibly apply where a beneficiary of a retirement plan or I.R.A. or a shareholder of a tax-exempt entity gets a distribution from the entity that is attributed to its investment in a P.F.I.C. The I.R.S. recently issued Notice 2014-28 that alleviated this concern. As a result, a shareholder of a tax-exempt organization or a beneficiary of a tax exempt retirement plan or I.R.A. is not subject to the P.F.I.C. rules. This notice alleviates not only possible adverse tax results, but also the need to file any relevant P.F.I.C. tax forms such as Form 8621, Information Return for a shareholder of a P.F.I.C.

I.R.S. Issues Regulations Regarding P.F.I.C. Reporting Requirements

Read Publication

On December 30, 2013, the I.R.S. released temporary and final regulations regarding P.F.I.C. reporting requirements. In T.D. 9650, the I.R.S. reaffirmed that it would not require any U.S. persons that owned any interest in a P.F.I.C. during 2010, 2011 or 2012 to file an information return on Form 8621 under the new rules unless they sold the stock, received a distribution or needed to make a P.F.I.C. election. However, Form 8621 will be required to be filed by any U.S. person that owned at any time during 2013 an interest in a P.F.I.C. Thus the form will filed with the 2013 income tax return that must be filed later this year.

The regulations adopted rules addressing constructive or indirect ownership. The constructive ownership or attribution rules can cause a person to become an owner of an interest in a P.F.I.C. even though no stock is directly owned in the P.F.I.C. As a result, ownership of P.F.I.C stock by a corporation, partnership, trust or estate can be attributed to the entity’s shareholders, partners or beneficiaries, who then can become subject to the P.F.I.C. rules.

BACKGROUND

U.S. investors must determine if any foreign corporation owned may be classified as a P.F.I.C. A foreign corporation will be classified as a P.F.I.C. if either (i) 75% or more of the corporation's gross income is passive income (such as from interest, dividends or capital gains) or (ii) 50% or more of the corporation's assets are held for the production of passive income (such as stocks, bonds or cash). A typical P.F.I.C. is an offshore investment company or mutual fund although P.F.I.C. status can be a potential issue for any foreign corporation, especially if the corporation has large cash reserves or is in the services business outside the U.S.