CFC's treatment of partnership income.
The final rules extend further the IRS's grip on the worldwide income of U.S. multinationals and also fuel claims that the U.S. tax system is anti-competitive. The proposed regulations published on Sept. 20, 2000 aimed to close an income-deferral loophole left by the Eighth Circuit's decision in Brown Group Inc., 77 F3d 217 (8th Cir. 1996). Treasury, in its nonacquiescence of that decision, was concerned that taxpayers could circumvent the subpart F regime (which was created to defeat income deferral, by doing indirectly through a partnership what could not be done directly via a CFC). Although the final regulations adopt the proposed regulations' concepts, they may have gone too far; income from even a nominal foreign partnership interest can result in current taxation.
Subpart F aims to prevent U.S. taxpayers from deferring recognition of certain categories of income from foreign subsidiaries incorporated outside the U.S. for the apparent sole purpose of reducing their U.S. tax liability.
Under Sec. 951(a), a U.S. shareholder of a CFC must include in gross income his or her pro-rata share of the CFC'S subpart F income. Sec. 957 defines a CFC as any foreign corporation in which more than 50% (by vote or value) of its total stock is owned by U.S. shareholders. According to Sec. 951(b), a U.S. shareholder is a U.S. person who owns (directly or indirectly) at least 10% of the total combined voting power of all CFC stock classes entitled to vote.
One category of subpart F income is foreign-base-company (FBC) in-come, which is subdivided into five categories, two of which are discussed in this item--FBC sales income and FBC services income. The former is generated from specific purchases and sales of personal property between a CFC and a related person located outside the CFC's country of incorporation. According to Sec. 954(d)(1), the specific transactions include a (1) purchase of personal property from a related person, and the sale of such property to any person; (2) sale of personal property to any person on a related person's behalf; (3) purchase of personal property from any person, and sale of that property to a related person; or (4) purchase of personal property from any person on a related person's behalf.
According to Sec. 954(e)(1), FBC services income is that derived from technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial or similar services performed for or on behalf of a related person outside the country of the CFC's incorporation; see Secs. 952 and 964.
The final regulations address the IRS's concern that if transactions were characterized at a partnership level, they would not be deemed subpart F income. The regulations combat this possibility by requiring characterization at the CFC partner level using the aggregate theory. Thus, under the final regulations, a CFC's distributive share of partnership income will be considered subpart F income, to the extent such income would have been subpart F income if received directly by the CFC partner. However, the final regulations require this characterization for all partnership interests held by the CFC, despite comments received from tax practitioners to limit these rules to more than a de minimis partnership interest.
For example, the rules could have applied to only more-than-50%-owned partnerships (i.e., controlled partnerships) or to only more than a 10% or a 20% interest when significant influence over partnership affairs could be argued. Not creating a minimum ownership makes the subpart F "control" requirement seem unnecessary. Without a minimum threshold, CFCs are required to obtain information even from foreign partnerships in which they own less than 1%, even though the partnerships are not required to file a Schedule K-1 nor separately track subpart F-type transactions. (Taxpayers who own 10% interests in foreign partnerships are already required to file Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships.) In addition, without control, the CFC cannot force a partnership to make cash distributions to pay for the tax on the income.
Although Treasury does not believe that applying these rules will cause significant problems, most international tax practitioners agree that compliance will be onerous, at best.
The following example was extrapolated from Regs. Sec. 1.954-1(g)(3).
Example: Unrelated U.S. corporations A, B, C, D and E each own 10.1% of CFC Z, organized in country T. The remainder of Z is owned by non-U.S, persons. Z was formed solely to act as a purchasing agent for its various European shareholders. Z enters into a joint venture with independent agent I in country R, to purchase products intended for sale in various countries by U.S. corporation S, also owned by A, B, C, D and E. Z forms partnership P with I in country T.Z has a 1% interest in P; I has the remaining 99% interest. P earns commissions by purchasing product O on S's behalf from unrelated manufacturers in R, for S to sell in various countries, including T.
To determine whether Z'S distributive share of P's income is FBC sales income under Sec. 954(d), Z would be treated as if it had purchased O on behalf of S, which is considered a related-party U.S. corporation under Sec. 954(d)(3). Thus, Z's sales income would be deemed to be derived from the purchase of personal property on a related person's behalf. Because the property purchased' is both manufactured and sold for use outside of T (Z's country of organization), Z's distributive share of P's sales income is FBC sales income.
In the example, neither control nor influence over partnership affairs is needed for subpart F rules to apply to CFCs with partnership investments. Interestingly enough, Regs. Sec. 1.9544(b)(2)(iii), which covers the characterization of services income, requires "control" for determining whether FBC services income exists. It states:
A controlled foreign corporation's distributive share of a partnership's services income will be deemed to be derived from services performed for or on behalf of a related person, within the meaning of section 954(e)(1)(A), if the partnership is a related person with respect to the controlled foreign corporation, under section 954(d)(3), and, in connection with the services performed by the partnership, the controlled foreign corporation, or a person that is a related person with respect to the controlled foreign corporation, provided assistance that would have constituted substantial assistance contributing to the performance of such services, under paragraph (b)(2)(ii) of this section, if furnished to the controlled foreign corporation by a related person. (Emphasis added.)
Based on the regulation, if the facts in the above example were the same, except that P was performing services with substantial assistance (as defined in the regulations) from Z, Z's distributive share of P services income would not be subpart F income. Apparently, in this instance, Treasury thought control was required.
The final regulations can either be a blessing or a curse, depending on whether the CFC wants to create subpart F income. For example, a U.S. corporation may have loss carryforwards that are expiring and may need additional income. In such case, the use of a noncontrolled foreign partnership (or deemed partnership under the check-the-box-rules), rather than a noncontrolled foreign corporation, would be advisable to generate taxable income.
The final regulations accomplish Treasury's goal that subpart F cannot be circumvented by use of a partnership. Practitioners must prepare by obtaining information from foreign partnerships needed to comply with the increasingly complex international tax rules. They should consider providing supplemental subpart F information on Form 8865. The final regulations are effective for CFC tax years after July 22, 2002.
FROM LEO PARMEGIANI, CPA, PKF NEWYORK, NY
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|Title Annotation:||controlled foreign corporations|
|Publication:||The Tax Adviser|
|Date:||Nov 1, 2002|
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