Forms of overseas operations.

EXECUTIVE SUMMARY

* A partnership may allow immediate flowthrough of FTCs and losses, but is subject to complex U.S. rules when allocating income, gain, losses and taxes.

* Foreign corporations are generally the preferred choice for domestic C corporations when the primary goal is deferral of U.S. income tax; a C corporation can claim an indirect FTC when foreign subsidiaries distribute earnings.

* U.S. shareholders of foreign corporations can be subject to tax under the CFC and PFIC anti-deferral provisions; the FPHC provisions have been repealed.

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This two-part article explores the major characteristics, advantages and disadvantages of the different forms of business organizations available for conducting business overseas. Part II discusses foreign partnership and corporate organizations.

U.S. companies doing business in a foreign country generally can choose to operate a branch, partnership or corporation. This two-part article examines the tax consequences of these alternatives. Part I, in the March 2005 issue, focused on branch operations. Part II, below, examines foreign partnership and corporate entities.

Partnerships

Under the check-the-box regulations, a foreign business entity that is not a corporation per se can elect to be treated (or be treated by default) as a partnership if it has two or more members. The partnership's income and losses flow through to its U.S. partners. However, the U.S. partnership tax rules add complexities to a foreign partnership's operations. As a result, the partnership agreement should address all the important tax and nontax issues. If it does not, local law will be deemed to be part of the agreement, under Regs. Sec. 1.761-1(c). To avoid future confusion and conflict, any differences between foreign laws and U.S. rules (on allocations and distributions, for example) should be addressed and resolved at partnership formation.

Substantial Economic Effect

A key tax feature of U.S. partnerships is their ability to allocate items of income, gain, loss and deduction among the partners in ratios that differ from those in the partners' capital accounts. Disproportionate or special allocations, however, must satisfy the "substantial economic effect" regulations under Sec. 704(b); under Regs. Sec. 1.704-1(b)(2)(ii), the following provisions should be in the partnership agreement:

1. The partners' capital accounts will be maintained in accordance with Regs. Sec. 1.704-1(b)(2) (iv);

2. Liquidating distributions will be made in accordance with the partners' positive capital account balances; and

3. A deficit capital account balance will be unconditionally restored by a partner following the liquidation of its partnership interest, or be subject to the qualified income offset rules of Kegs. Sec. 1.704-1(b)(2)(ii)(d).

Sec. 704(c) Gain/Loss

Another vital tax feature of U.S. partnerships is the Sec. 704(c) built-in gain (BIG) or loss (BIL) allocation rules. Sec. 704(c) applies to a contribution of property when its fair market value (FMV) differs from its tax basis (i.e., it has BIG or BIL). Sec. 704(c) allocates the BIG or BIL to the contributing partner. The partnership agreement should specify the allocation method(s), giving due consideration to the anti-abuse rules in Regs. Sec. 1.704-3(a)(10).

The American Jobs Creation Act of 2004 (AJCA), Section 833(a), created new Sec. 704(c)(1)(C), which requires the BIL on contributed property to be allocated only to the contributing partner. The property's basis would be treated as equal to its FMV at contribution for the purpose of allocating items to the noncontributing partners.

New BIL Basis Adjustment Rules

AJCA Section 833(b) and (c) mandate a basis step-down in partnership assets if a "substantial" BIL (or a substantial basis reduction) exists when a partnership interest is transferred (or liquidated). For a transfer of a partnership interest, a substantial BIL exists if the partnership's aggregate adjusted basis in all of its property exceeds the aggregate FMV of its property by more than $250,000, under new Sec. 743(d).

Under new Sec. 734(d), there is a substantial basis reduction when a partnership interest is liquidated, if the sum of the (1) redeemed partner's recognized loss and (2) portion of the distributed property's substituted basis in the redeemed partner's hands that exceeds the partnership's adjusted basis, is more than $250,000.

DCL 

Another complexity is how to compute a partnership interest's dual consolidated loss (DCL), as the IRS has yet to issue any guidance. Without special allocations, a partner's allocable share of partnership loss should be that partner's DCL. However, it is unclear how the partner's DCL would be determined if a loss item were allocated to a U.S. partner for U.S. tax purposes, and to a foreign partner for foreign tax purposes.

Interest Expense Apportionment 

Special rules apply to the apportionment of partnership interest expenses. A corporate general partner or any limited partner cannot allocate its share of partnership interest expenses between foreign- and U.S.-source income for foreign tax credit (FTC) purposes if its partnership interest is less than 10%. Instead, under Temp. Regs. Sec. 1.861-9T(e)(4), its distributive share of interest expense has to directly offset its share of partnership gross income. This rule can reduce the FTC limit, because the partnership's foreign-source income is fully decreased by the interest expense.

Another problem occurs when a U.S. partner makes a loan to a foreign partnership. Generally, interest expense is apportioned between foreign- and U.S.-source income based on the taxpayer's source of assets. A loan to a foreign partnership potentially requires the U.S. partner to double-count the foreign-source assets when apportioning interest expense, because the loan would be reflected in the foreign-source asset basis twice. The partner's basis in the loan is reflected as a receivable from the foreign partnership. In addition, the partner has an allocated share of its loan as the basis in its partnership interest, under Secs. 752(a) and 722. This double-counting of the loan as foreign-source assets can result in (1) disproportionately more interest expense being apportioned to foreign-source income and (2) a reduction in the FTC limit. (20)

Transfer Pricing 

Transactions between a partnership and a U.S. partner are subject to complex transfer-pricing rules. A U.S. taxpayer must maintain contemporaneous documentation to establish the reasonableness and reliability of its transfer-pricing methods. Failure to comply can result in a transfer-pricing penalty on a substantial tax under-payment. Under Sec. 6662(a) and (h), the penalty is 20% or 40% of the underpayment, depending on the amount of the transfer-pricing adjustment.

Partnership Income Tax Allocations

Finally, the allocation of foreign income taxes among partners has been an area of considerable uncertainty. Foreign income taxes pass through from the partnership to the partners. Under Sec. 702(a)(6), each partner includes its distributive share of the partnership's foreign income taxes as if it had incurred the taxes. In April 2004, the IRS issued temporary regulations and identical proposed regulations addressing the allocation of foreign taxes among partners in a partnership. (21)

Temp. Kegs. Sec. 1.704-1T(b) (4)(xi)(a) provides that foreign taxes must be allocated in accordance with the partners' partnership interests. An allocation is deemed to be in accordance with these interests when the substantial economic effect provisions (described above) are met and the foreign tax is allocated in proportion to the partner's distributive share of income to which the tax relates. A foreign tax is related to income when the income is included in the base on which the tax is imposed. If an allocation does not satisfy this safe harbor, the general test of a partner's interests applies. Under this test, relevant factors include relative capital contributions and interests in profits and losses and in cashflow and liquidation proceeds.

The temporary regulations generally apply to partnerships formed after April 20, 2004. However, under Temp. Regs. Sec. 1.704-1T(b)(1)(ii)(b), related-party partnerships (as described in Secs. 267(b) and 707(b)) are subject to the new regulations if the related parties can amend the partnership agreement without third-party consent.

Foreign Corporations

Although a U.S. taxpayer is subject to income tax on its worldwide income, a foreign corporation is taxed only on its U.S.-source income. A foreign corporation's operating income not "effectively connected with" a U.S. trade or business is not subject to U.S. income tax. The foreign corporation's U.S. shareholders are generally not taxed until the foreign income is distributed to them.

A foreign corporation is the preferred choice of entity if the primary goal is to defer U.S. income tax. As stated in Part I of this article, it is generally preferred for domestic C corporations. For other U.S. entities, a branch (or partnership) is generally the better choice. The difference in choice between a C corporation and another entity type is primarily attributable to the indirect FTC under Secs. 902 and 960.

Dual-Incorporated Entity

On Aug. 12, 2004, the IRS issued temporary and proposed regulations on how a business entity is treated for U.S. tax purposes when it is organized in more than one country (a dual-incorporated entity). Under Temp. Regs. Sec. 301.7701-2T(b)(9)(i), such an entity is taxed as a corporation if it is deemed a corporation for U.S. tax purposes in any jurisdiction in which it is created or organized. Further, Temp. Regs. Sec. 301.7701-5T(a) provides that an entity is a domestic entity if it is organized in the U.S., regardless of whether it is also organized in a foreign jurisdiction. Thus, a dual-incorporated entity cannot be a foreign corporation if it is also organized in the U.S; instead, it is taxed as a U.S. taxpayer.

Indirect FTC

A domestic C corporation can claim an indirect tax credit for foreign taxes paid by its foreign subsidiaries when the latter's earnings are actually (or deemed) distributed. Under Secs. 902 and 960, this credit is generally available to a domestic C corporation with a 10%-or-more ownership interest (voting power) in the first-tier foreign subsidiary.

Starting in 1987, the indirect FTC calculation was based on a pool (i.e., the foreign corporation's pool of post-1986 earnings and profits (E&P) and foreign taxes). Under Sec. 902(a), the indirect FTC from a dividend is the share of foreign taxes accumulated in the post-'86 pool that is in proportion to the dividends distributed from the foreign corporation's post-'86 accumulated E&P.

The indirect FTC can also be claimed for foreign income taxes paid by the next five tiers of foreign corporations, when specific ownership requirements are met. The first-tier foreign corporation's pool of foreign taxes includes a proportionate share of those paid by the lower-tier corporations on dividends distributed to the first-tier corporation. The indirect FTC from lower tiers becomes available to the domestic C corporation when the first-tier foreign corporation makes (or is deemed to have made) a dividend distribution. Under Sec. 902(b), the specific ownership requirements for indirect FTCs are as follows:

1. The immediate corporate shareholder of each tier must directly own at least 10% of that tier's voting stock.

2. The U.S. corporate shareholder must indirectly own at least 5% of the voting stock of each tier, starting from the second tier down. Indirect ownership is computed by consecutively multiplying the voting stock ownership percentages of at least 10% held by respective immediate shareholders through the chain of foreign corporations, stopping at the tier being tested for the prerequisite ownership requirement.

3. A foreign corporation below the third tier must be a controlled foreign corporation (CFC) and the U.S. corporation must be a U.S. shareholder (as defined in Sec. 951(b) and described below) of the foreign corporation.

Asset Transfers

A contribution of assets to a foreign corporation is generally tax free under Secs. 351 and 367(a)(3)(A) if the entity intends to use them in the active conduct of a foreign trade or business outside the U.S. However, under Sec. 367(a)(3)(B) and Temp. Regs. Sec. 1.367(a)-5T, a U.S. shareholder must recognize gain on "tainted assets," which include (1) inventory and copyrights" (2) installment obligations and receivables; (3) foreign currency or property denominated in foreign currency; and (4) leased property. There is also recapture when depreciated property is transferred, under Temp. Regs. Sec. 1.367(a)-4T(b)(1).

Under Sec. 367(d), a U.S. person's contributions of intangible assets to a foreign corporation are treated as sales made for annual payments contingent on the productivity, use or disposition of such property. Thus, a contribution of intangibles to a foreign corporation triggers deemed royalty income to a U.S. shareholder over the property's useful life, which will generally not exceed 20 years. An incorporation of an existing branch can also trigger income recognition if it has previously deducted, but not yet recaptured, foreign losses. (22)

Anti-Deferral Provisions

While a foreign corporation's foreign income is generally not taxable, three key anti-deferral provisions can apply to tax U.S. shareholders on income that has not been repatriated: the rules for (1) CFCs, (2) foreign personal holding companies (FPHCs) and (3) passive foreign investment companies (PFICs). However, AJCA Section 413 repealed the FPHC rules, effective for tax years of foreign corporations beginning after 2004.

CFCs

A foreign corporation is a CFC if more than 50% of the vote or value of its stock is owned--directly, indirectly or constructively--by U.S. shareholders. (23) Under Secs. 951(b) and 958, a U.S. shareholder is a person who owns--directly, indirectly or constructively--10% or more of a foreign corporation's voting stock.

If a foreign corporation is a CFC for at least 30 consecutive days during a tax year, a U.S. shareholder who owns stock on the last day of the CFC's tax year generally must include in gross income, a pro-rata share of the CFC's subpart F income and the increase in earnings invested in U.S. property, under Secs. 951(a)(1) and (2).

Subpart F Income

The most common component of subpart F income is foreign base company income, which consists of FPHC income (FPHCI) (e.g., passive income), foreign base company (FBC) sales or services income and FBC income from special industries. (24)

Definitions: FPHCI includes dividends, interest, rents, royalties, net gains from the sale of stock and securities, factoring income, net commodities gains, income from notional principal contracts and net gains from certain foreign currency activities. (25) Effective for tax years beginning after 2004, AJCA Section 413(b)(2) amended Sec. 954(c)(1)(I), so that FPHCI includes income from personal services performed by a 25% (or more) shareholder if a person other than the CFC can designate who is to perform the services (or if the contract designates the service provider).

FBC sales income is income from certain related-party sales or purchases by a CFC of property produced and sold for use outside its country of incorporation. Under Sec. 954(d)(1) and Regs. Sec. 1.954-3(a), this includes the purchase of personal property from a related person for resale to any person; the sale of personal property to any person on behalf of a related person; the purchase of personal property from any person for resale to a related person; and the purchase of personal property from any person on behalf of a related person. FBC sales income generally does not include income from sales of property produced by a CFC. (26) Under Sec. 954(d)(3), a related person is an (1) individual or entity that controls the CFC (i.e., has more than 50% vote or value), (2) entity controlled by the CFC or (3) entity controlled by the CFC's owners (e.g., brother-sister entities).

According to Regs. Sec. 1.954-4, FBC services income is derived from performing technical, managerial, engineering and similar services for, on behalf of or with the substantial assistance of, a related person outside the CFC's country of incorporation.

If total FBC and insurance income (determined without regard to deductions) for the tax year is less than 5% of gross income and $1 million, the corporation is treated as having no FBC income. (27) Conversely, under Sec. 954 (b)(3)(B), if such income exceeds 70% of the corporation's gross income, all of the gross income would be FBC income.

Subpart F income included in income for any given year may not exceed the CFC's current E&P, under Sec. 952(c)(1)(A). If subpart F income is reduced due to the E&P limit, the reduction is subject to recapture in subsequent years, under Sec. 952(c)(2).

Under Sec. 954(b)(4), a U.S. shareholder can exclude FBC income as subpart F income if it was subject to an effective tax rate by the foreign country greater than 90% of the maximum U.S. income tax rate. The income is excluded by attaching a statement to the income tax return, under Regs. Sec. 1.954-1(d).

When a CFC's subpart F income is taxed, the stock basis is increased by the income inclusion under Sec. 961(a). If the amounts taxed earlier are distributed, the distribution is not taxed again, but stock basis is reduced, under Secs. 959(a) and 961(b).There are specific ordering rules for the year, character and source of a distribution. (28)

Exchange gain or loss: While a distribution of previously taxed income (PTI) is not taxed again, it can result in foreign currency gain or loss under Sec. 986(c). According to Notice 88-71, (29) the exchange gain or loss from a PTI distribution is basically the difference between the dollar value of the distribution (i.e., the foreign currency distribution x the spot rate on the distribution date) and its U.S. dollar basis. To compute the dollar basis, two pools of post-'86 undistributed PTI (i.e., a pool in U.S. dollar basis and a pool in the foreign currency) are maintained. When a PTI distribution is made, the distribution's dollar basis is the post-'86 undistributed PTI from the dollar basis pool, in proportion to the amount of foreign currency distributed from the foreign currency pool.

Increase in Earnings Invested in U.S. Property

A CFC's investment in U.S. property is treated as a repatriation of earnings to its U.S. shareholders and, thus, is potentially subject to U.S. income tax. Under Sec. 956(a)(1), a U.S shareholder must determine the increase in earnings invested in U.S. property, which is the lesser of the shareholder's pro-rata share of the:

1. Quarterly average of the amounts of U.S. property held by the CFC, reduced by earnings previously taxed as investments in U.S. property; or

2. CFC's applicable earnings (i.e., the CFC's current and accumulated earnings, reduced by distributions made during the year and earnings previously taxed as investment in U.S. property (and excess passive assets before 1997)). (30)

If the increase in earnings invested in U.S. property is attributable to amounts previously taxed as subpart F income, Secs. 951(a)(1)(B) and 959(a)(2) provide that such amounts are also not taxed. In effect, U.S. shareholders are not taxed on a CFC's U.S. property investment until it exceeds the CFC's undistributed previously taxed subpart F income.

Under Sec. 956(c), U.S. property includes tangible property located in the U.S., any stock or obligation of a related U.S. person (i.e., a 10% U.S. shareholder or a 25% related U.S. corporation) and any right to use certain intangibles (e.g., patents and copyrights) acquired or developed by the CFC for use in the U.S. U.S. property does not include U.S. obligations, U.S. bank deposits, stock in unrelated U.S. corporations and tangible property purchased and located in the U.S. for export.

FPHCs

Under AJCA Section 413, the FPHC rules are repealed, effective for tax years beginning after 2004. Under pre-AJCA Sec. 552(a), a foreign corporation was an FPHC when more than 50% of its voting power or value was owned (directly, indirectly or constructively) by five or fewer U.S. citizens or residents and at least 60% of its gross income was FPHC income. (31) Generally, a foreign corporation that actively engages in a business should not be an FPHC, except during its start-up period.

PFICs

A foreign corporation is a PFIC when either (1) 75% of its gross income is passive income or (2) 50% of its assets are held for the production of passive income, under Sec. 1297(a). Limited exceptions apply to start-up corporations and corporations that temporarily change their business under Sec. 1298(b)(2) and (3).There is no minimum U.S. stock ownership threshold.

Under the so-called "once a PFIC, always a PFIC" taint of Sec. 1298 (b)(1), a foreign corporation can be treated as a PFIC at all times as to a shareholder if the foreign corporation was a PFIC at any time during the shareholder's holding period. In effect, the shareholder is subject to the PFIC rules even if the foreign corporation no longer meets either the passive income or the asset test.

Passive income generally includes interest, dividends, royalties, rents, annuities and gain from the disposition of assets that generate passive income and from the sale of assets that do not currently produce income, under Secs. 1297(b) and 954(c). Assets are characterized by the income they produce; an asset is passive if it generates passive income. Cash is considered a passive asset, even though maintaining certain cash reserves is vital to a business. (32) A foreign corporation actively engaging in a business can be a PFIC if it has limited inventory, equipment and machinery.

The PFIC rules can apply simultaneously with both the CFC and repealed FPHC rules. However, under Sec. 1297(e)(1) and (2), a U.S. shareholder (owning 10% or more voting stock) of a CFC formed after 1997 is not subject to the PFIC provisions if that shareholder is not subject to the PFIC taint. Taxpayers owning a lesser interest in a CFC are still subject to the PFIC rules, under Secs. 1297(e)(1) and (2).

The PFIC taint generally occurs if the U.S. shareholder was subject to the PFIC rules in a preceding year and did not make a Sec. 1295 "qualifying electing fund" (QEF) election (discussed below) in the first PFIC year. As discussed below, the U.S. shareholder can purge the PFIC taint and avoid CFC/PFIC overlap if a timely election is made under Sec. 1298(b)(1).

If a taxpayer is subject to the PFIC rules, two tax regimes can apply, either separately or together. The deferred-tax-charge regime applies if the shareholder either does not make a QEF election or makes one after the first year of owning PFIC stock. (33) The QEF regime applies when the shareholder makes the QEF election under Sec. 1293. Both tax regimes can apply if the shareholder makes the QEF election after the first year of owning PFIC stock.

Deferred-tax-charge regime: Under this regime, a shareholder will be subject to the "once a PFIC, always a PFIC" taint of Sec. 1298(b)(1). The shareholder can purge the taint by making both a QEF election and one to trigger the deferred tax charge as if the shareholder had sold the stock. (34) Gain recognized on the deemed sale is subject to the deferred tax charge. If the foreign corporation is a CFC, a shareholder may be able to make these elections as if the shareholder had received a dividend equal to its share of the CFC's post-'86 earnings. (35) An allocated portion of the deemed dividend is subject to the deferred tax charge.

This regime does not tax the U.S. taxpayer until income is distributed or the stock is disposed. However, the deferred tax charge (which includes interest) is imposed on dividends or gains from a stock disposition, under Sec. 1291(a)-(c). According to Prop. Regs. Sec. 1.1291-2(c) and-3(a),indirect distributions and dispositions are also subject to this charge. Under Prop. Regs. Sec. 1.1291-3(e) and -2(f),indirect distributions and dispositions include (1) dividends to an actual owner of the stock, whose ownership is attributable to the U.S. taxpayer; (2) dispositions of the stock by an owner whose ownership is attributable to the U.S. taxpayer; and (3) dispositions by the U.S. person of an interest that has the effect of reducing or terminating its indirect PFIC ownership interest. According to Prop. Regs. Sec. 1.1291-6, the deferred-tax-charge regime generally requires gain recognition on a direct or indirect disposition, even if the transfer would have otherwise been tax free.

Under this regime, dividend distributions in a tax year that exceed 125% of the average distributions for the last three years (i.e., the excess distribution) and gains from stock dispositions are allocated ratably to each day of the U.S. taxpayer's stockholding period, under Secs. 1291(a) and (b). Amounts allocated to the current tax year and to years before the foreign corporation became a PFIC are taxed as current-year ordinary income (not as capital gain). Under Sec. 1291(c), amounts allocated to prior PFIC years are taxed at the top marginal rates applicable to those years, as if they were received by the taxpayers in those years. Interest is also assessed.

In essence, the deferred-tax-charge regime treats distributions and gains as though they were received pro rata throughout the shareholder's PFIC stockholding period. The deferred tax charge is the tax that would have been owed had the allocated gain or excess distributions been included in income and taxed at the highest rate in the earlier PFIC years, plus interest.

QEF regime: If a shareholder makes a QEF election, the PFIC's earnings are taxed currently under Sec. 1293(a). A QEF election can be made in any tax year in which the foreign corporation is a PFIC. An election to defer the tax payment on the reported income can be made under Sec. 1294(a), but the election is not available to the extent that the income is also taxable under the CFC or repealed FPHC provisions. If a shareholder makes a QEF election in the first tax year the corporation is a PFIC, the PFIC taint does not apply. Accordingly, the shareholder includes the PFIC's earnings only in the year in which the foreign corporation meets the PFIC tests. If a QEF election was not made in the first year the corporation was a PFIC, the shareholder must report the PFIC's earnings every year, because of the PFIC taint. (36)

Conclusion

From a tax standpoint, the structure selected for an overseas operation should minimize the present value of overall foreign and U.S. tax burdens on a long-term basis. To minimize U.S. income tax, a U.S. taxpayer generally must optimize its use of FTCs. A branch or a partnership might allow a U.S. taxpayer to deduct foreign start-up losses against U.S.-source income. The foreign losses can be beneficial if U.S. taxes are reduced, even if they can be recaptured as U.S.-source income in the future. A branch (or a partnership) provides an immediate flowthrough of income and FTCs to U.S. taxpayers.

A foreign corporation can help control and defer the flow of foreign-source income. However, losses cannot directly offset the U.S. taxpayer's income. In addition, a foreign corporation cannot pass through its foreign taxes (i.e., indirect FTC) to U.S. taxpayers that are not C corporations.

The decision to operate abroad through a branch, partnership or foreign corporation can be complex. A selection without careful consideration may result in costly tax consequences.

(20) For further discussion, see Lemein and McDonald, "International Tax Watch--Interest Apportionment Rules Can Double-Count Foreign Source Assets in Certain Joint Venture Transactions," 81 Taxes 5 (September 2003).

(22) See the potential income recapture under (1) the foreign asset disposition rules of Sec. 904(0(3) and (5)(F) and Regs. Sec. 1.904(f)-2(d); (2) the branch loss recapture rules of Sec. 367(a)(3)(C) and Temp. Regs. Sec. 1.367(a)-6T; and (3) the DCL recapture rules of Regs. Sec. 1.1503-2(g)(2)(iii)(A)(5) and (7).

(23) See Secs. 957(a) and 958. Indirect ownership is beneficial ownership through foreign intermediaries and applies until a U.S. person is deemed to own the CFC's stock; see Sec. 958(a)(2). Constructive ownership is beneficial ownership attributed from related persons or entities under Sec. 318(a), subject to certain modifications under Sec. 958(b). Special roles apply to foreign insurance operations under Secs. 957(10) and 953(c).

(24) See Secs. 952(a)(2) and 954(a). Other components of subpart F income are (1) income from "blacklisted" countries; (2) income connected with international boycotts; (3) illegal payments to government officials; and (4) insurance income. Special industries are shipping and oil-related industries. Shipping income includes the use (or hiring or leasing for use) of any aircraft or vessel and services directly related to such use; see Secs. 954(f) and (g). For tax years beginning after 2004, shipping income is no longer subpart F income.

(25) There are exceptions to the passive income provisions. For example, under Sec. 954(c)(2)(B), export financing interest received in the active conduct of a banking business is not passive income. Qualified banking, financing or insurance income is also excluded; see Sec. 954(h) and (i). Under Sec. 954(c)(3), interest received from a related person can be excluded as passive income if the (1) related borrower and lender are corporations created or organized in the same foreign country, (2) borrower uses a substantial part of its assets in a trade or business located in that country and (3) interest payment does not reduce the related borrower's subpart F income. Rents and royalties may be excluded from passive income if (1) derived from the active conduct of a wade or business and not received from a related person or a related corporation for the use of property in the same country in which the CFC is organized and (2) the payments do not reduce the related payer's subpart F income; see Sec. 954(c)(2)(A) and (3). Income from certain commodities transactions is also excluded, under Sec. 954(c)(1)(C). Exceptions are available under Sec. 954(c)(2)(C) for securities dealers.

(26) To prevent a CFC from using a branch in another country to avoid subpart F income, Sec. 954(d)(2) treats a branch as the CFC's wholly owned subsidiary. Under Regs. Sec. 1.954-3(b), a sale branch is treated as the CFC's wholly owned subsidiary if it is located in another country and its income is subject to a materially lower effective tax rate than the CFC's income. A tax is "materially lower" if the income attributed to the sales is taxed at an effective rate less than 90% of, and at least five percentage points less than, the effective rate that would apply to the sales income if it were earned in the country in which the manufacturing activity is located. Conversely, if the branch is engaged in manufacturing and the CFC is engaged in sales, the manufacturing branch is treated as a wholly owned subsidiary if the CFC's effective tax rate is materially lower than the branch's.

(27) See Sec. 954(b) (3)(A) and Regs. Sec. 1.954-1(b)(1). Under Kegs. Sec. 1.954-1(b)(1)(i)(C), the de minimis rule does not apply to income earned from trade or services receivables acquired from a CFC's related party, or to loans to finance the purchase of goods or Services from a related party. Accordingly, income from these sources is FBC income reportable by U.S. shareholders.

(28) See Kegs. Sec. 1.959-1, et seq. and Notice 88-71, 1988-2 CB 374.

(29) Notice 88-71, note 28 supra.

(30) See Sec. 956(b) (1). Current earnings are not reduced by the accumulated deficit of prior years. Thus, a U.S. shareholder can have income even if the CFC had current earnings, but an overall accumulated deficit.

(31) The 60% income threshold was reduced to 50% after the first year the foreign corporation was an FPHC.

(32) See Notice 88-22, 1988-1 CB 489.

(33) See Sec. 1291(d)(1) and Prop. Regs. Sec. 1.1291-1(c)(2).

(34) See Sec. 1291(d)(2)(A) and Regs. Sec. 1.1291-10(a).

(35) See Sec. 1291(d)(2)(B) and Regs. Sec. 1.1291-9(a).

(36) See Prop. Regs. Sec. 1.1293-1(a) and Temp. Kegs. Sec. 1.1297-3T(a).

Editor's note: Mr. Lau is a member of the AICPA Tax Division's International Tax Technical Resource Panel.

Paul C. Lau, ABV, CMA, CPA 

Partner

Blackman Kallick Bartelstein, LLP 

Chicago, IL

Michael G. Shum

University of California, Berkeley 

Berkeley, CA

For more information about this article, contact Mr. Lau at [e-mail]