New subpart F lookthrough rules.

A single provision that will have a powerful effect on U.S. multinationals involves the new subpart F lookthrough rules. On May 17, 2006, Congress passed the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). One of the TIPRA's provisions allows related parties of certain controlled foreign corporations (CFCs) to transfer international earnings without triggering subpart F income. In general, this new provision provides an exception from the subpart F rules for dividends, interest, rents and royalties received from related CFCs, if the income that gives rise to the repatriated earnings does not originate from subpart F income when earned by the CFC.

Overview

In general, under subpart F, U.S. persons who are 10% shareholders ("U.S. shareholders") of a CFC are required to recognize their pro-rata share of subpart F income under Sec. 951 (a) (1). Such income includes foreign personal holding company income (FPHCI), generally consisting of dividends, interest, rents and royalties. Sec. 957(a) provides that a foreign corporation is a CFC if it is owned more than 50% by U.S. shareholders. If a CFC generates subpart F income, typically its U.S. shareholders must include a "deemed dividend" in income in the year the CFC earns the subpart F income (rather than when the CFC distributes the income).

An exception to subpart F income inclusion occurs (and, thus, a U.S. shareholder need not recognize the income) if the CFC's dividends or interest arise from a related corporation organized and operating in the same foreign country in which the CFC is organized. The "same country exception," included in Sec. 954(c)(3), also applies to a CFC's receipt of rent and royalties from a related corporation for the use of property within the country in which the CFC is organized. This exception does not apply if the payer's subpart F income is reduced by the interest, rent or royalty payments.

New Sec. 954(c)(6), enacted by TIPRA Section 103(b), treats dividends, interest, rent and royalties received or accrued from a related CFC to be outside the definition of FPHCI, to the extent attributable or properly allocable to the related person's income that is not subpart F income. This expansion of the law is meant to level the playing field for U.S. multinationals, as most foreign countries allow multinational companies to reinvest their active foreign earnings without an additional tax burden. The law will now provide U.S. multinational companies the same opportunity to transfer earnings among foreign related parties, regardless of the country of incorporation, without creating subpart F income.

For this purposes, a related CFC is either controlled by or controls another CFC, or is a CFC controlled by the same person controlling the other CFC. Control, for these purposes, is demonstrated by owning more than 50% of a corporation's stock (by vote or value). Note: This provision applies to tax years beginning after 2005 and before 2009.

Example 1: A U.S. parent company, X Corp., controls foreign company A, a holding company in a low-taxed jurisdiction, and foreign company 13, a per se corporation in a high-taxed jurisdiction (e.g., 32% rate) wholly owned by A. Before the TIPRA, B's payments of interest or royalties to A (located in a different country) would trigger subpart F income recognition in the U.S. at a higher rate. Under the new law, this transaction will not trigger U.S. recognition of subpart F income.

Example 2: The facts are the same as in Example 1. B has high-taxed earnings and profits (E&P) arising from non-subpart F income. B also has additional debt capacity and distributes a dividend to A; simultaneously, A makes a loan to B, or alternatively, B distributes a note to A; see the exhibit on p. 642. B's dividend and interest payments to A are not FPHCI, under Sec. 954(c)(6), and local foreign country deductions have been created for B in its high-taxed jurisdiction. Effectively, B's high-taxed E&P has been moved to A, with no U.S. subpart F income recognition.

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Before the enactment of Sec. 954(c)(6), taxpayers frequently had to restructure their foreign operations so that a CFC owned several foreign disregarded entities. The CFC would generally engage in financing transactions with these wholly owned entities, or the entities would enter into transactions among themselves. The redeployment of earnings within the group of foreign disregarded entities would not constitute FPHCI because, as foreign branches, such transactions were disregarded for Federal income tax purposes.

Burdens

While the new law poses many tax planning opportunities, there are a few drawbacks. For example, there will be Sec. 952(c) recapture if a CFC earned significant FPHCI over a period of years that did not generate subpart F income, and incurred non-subpart F losses during those same years. The new provision's lookthrough treatment of FPHCI income may trigger Sec. 952(c) recapture for the CFC's 2006-2008 tax years. Further, Sec. 954(c)(6) can cause double counting of E&P for related CFCs that have inter-company loan transactions, if the CFC obligor accrues (but does not pay) related-party interest on the loan transaction (due to the interaction of the provision with Sec. 267(a)(3)). Such traps, along with the current three-year time horizon, may pose some potential tax planning challenges. This only emphasizes the need for an exit strategy for when the new provision expires.

Conclusion

Sec. 954(c)(6) will allow taxpayers more flexibility in redeploying active trade or business earnings among related CFCs without creating additional U.S. taxation under the current subpart F anti-deferral regime. It allows taxpayers to do so without incurring substantial restructuring costs to achieve this flexibility, by using foreign disregarded entities. Although the provision may be extended beyond 2008, taxpayers should take appropriate steps to develop a plan that takes into account the new provision's three-year shelf life.

FROM FRANK LANDRENEAU, CPA, ANJANA JACKSON, CPA, AND RICHARD MORRISON, CPA, PKF TEXAS, HOUSTON, TX