Subpart F Income: Critical Tax Compliance and Audit Issues Compliance - - PowerPoint PPT Presentation

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Subpart F Income: Critical Tax Compliance and Audit Issues Compliance and Audit Issues

Mastering Income Calculation, Tax Rates, Audit Preparation and Other Complexities

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific WEDNES DAY, S EPTEMBER 28, 2011

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

Andrew Mitchel Owner Andrew Mitchel Essex Conn Andrew Mitchel, Owner, Andrew Mitchel, Essex, Conn. S am Kaywood, Partner, Alston & Bird, Atlanta Davis Wang, Sullivan & Cromwell, New Y

• rk

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S b t F I C iti l T Subpart F Income: Critical Tax Compliance and Audit Issues Seminar

S

• ept. 28, 2011

Andrew Mitchel, Andrew Mitchel LLC andrew@ andrewmitchel.com S am Kaywood, Alston & Bird sam.kaywood@ alston.com Davis Wang, S ullivan & Cromwell wangd@ sullcrom.com

Today’s Program

Determination And Tax Treatment Of A Controlled Foreign Corporation [S am Kaywood] S lide 7 – S lide 20 S elected Types Of S ubpart F Income [Andrew Mit chel and Davis Wang] S lide 21 – S lide 48 Compliance And Reporting Issues [Andrew Mit chel] Anticipating IRS Audit Red Flags S lide 55 – S lide 61 S lide 49 – S lide 54 p g g [Andrew Mit chel] Tax Planning Involving S ubpart F [S am Kaywood] S lide 62 – S lide 73 [S am Kaywood]

DETERMINATION AND TAX

Sam Kaywood, Alston & Bird

DETERMINATION AND TAX TREATMENT OF A CONTROLLED FOREIGN CORPORATION CORPORATION

Basics

US US Co F Co

• No U S Tax on F Co earnings until a repatriation event occurs
• No U.S. Tax on F Co earnings until a repatriation event occurs.

8

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Repatriation Events

Di id d f F C

• Dividend from F Co
• Subpart F income and §956 of CFC
• Passive foreign investment company (PFIC) income

– QEF Income Q

• Liquidation of CFC - §332 & 367(b)
• Sale of stock of CFC - §1248

– Portion of gain recharacterized as dividend

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Controlled Foreign Corporation

“U S Shareholder” 10% oting po er “U.S. Shareholder” = 10% voting power “CFC” = U.S. shareholders own more than 50% of vote or value

• Detailed attribution rules
• Detailed attribution rules
• Direct and indirect ownership - §958(a)
• Construction ownership - §318(a) / §958(b)
• Artificial arrangements designed to avoid CFC status normally don’t
• Artificial arrangements designed to avoid CFC status normally don t

work.

• Deadlock situations

10

Deadlock situations

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CFC Classification

Shareholders FCo Voting Common Stock

U.S.1 9 U.S.2 9 U S 3 9 U.S.3 9 U.S.4 9 U.S.5 9 U.S.6 9 Foreign1 46 100

FACTS:

• All shareholders are unrelated to each other.
• There is only one class of stock.

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RESULTS:

• No U.S. person owns 10% or more of the stock of FCo.
• Consequently, there are no U.S. shareholders in FCo, and

FCo is not a CFC.

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CFC Classification (Cont.)

Shareholders FCo Voting Common Stock FCo Non-Voting Preferred Stock

U.S.1 9 1000 U.S.2 9 1000 U S 9 1000 U.S.3 9 1000 U.S.4 9 1000 U.S.5 9 1000 U.S.6 9 1000 Foreign1 46

• 0-

100 6000

FACTS:

• All shareholders are unrelated.
• The U.S. persons owning stock own more than 50% of value of FCo.

100 6000

12

RESULTS: • FCo is not a CFC, because there are no U.S. shareholders.

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CFC Classification (Cont.)

Unrelated Shareholders FCo Voting FCo Non-Voting Unrelated Shareholders FCo Voting FCo Non Voting

U.S.1 9 1000 U.S.2 9 1000 U.S.3 9 1000 U.S.4 50 5000 Foreign1 23 2000 Foreign1 23 2000 100 10000 RESULTS: • Not a CFC. There is only one U.S. shareholder who does not own

more than 50% of vote or value.

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CFC Classification (Cont.)

FCo Voting FCo Voting FCo Non-Voting Cl C Unrelated Shareholders FCo Voting Class A 6 Directors FCo Voting Class B 4 Directors Class C 0 Directors

U S 1

2

• 0-

100

U.S.1

2 100

U.S.2

2

• 0-

100

U.S.3

2

• 0-

100 4 20

Foreign

4 20

• 0-

10 20 300

RESULTS: •

FCo is a CFC. U.S.1, U.S.2 and U.S.3 are all U.S. shareholders, because each holds 20% of the shares of the class possessing the power to elect a majority of the board. Treas. Reg. 1.951-1(g)(ii) (Example 2). Since these U.S. shareholders control the majority of

14

( p ) j y that class, they own more than 50% of the vote of FCo and FCo is a CFC. Treas. Reg. 1.957-1(b)(1).

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Attribution Rules: Constructive Ownership Constructive Ownership

USCO

FACTS: All ownership is with respect to both vote and value.

F1 (Germany)

51% 49% German Individual

RESULTS: F2 is a CFC, even though USCO owns

• nly 51% x 51% = 26% indirectly.

51%

Under § 958(b)(2), F1 is deemed to

• wn 100% of the voting power of F2

for purposes of attributing the hi f F2 t k f F1 t

F2 (U.K.)

49% U.K. Individual

• wnership of F2 stock from F1 to
• USCO. Thus, under § 318(a)(2)(C),

USCO is deemed to own the 51% of the voting stock of F2 that F1 is

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the voting stock of F2 that F1 is deemed to own under § 958(b)(2).

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Subpart F Income

E l f S b F i

• Foreign personal holding company name

Examples of Subpart F income

• Foreign personal holding company name

– Interest, rents, royalties or dividends (fruit) – Gain on sale of tree producing fruit (e.g., sale of stock, bonds, real property) (e.g., sale of stock, bonds, real property) – Gain on sale of partnership interest

• Foreign base company sales income

Foreign base company sales income

• Foreign base company services income

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§1248

• §1248 treats the E&P of CFC as a

dividend.

Buyer CFC Stock

USCo

• Carryout of FTCs for §902 purposes
• Applies to 10% shareholders of a CFC
• Applies to 10% shareholders of a CFC

CFC

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• Sect. 1248 Treatment On

Sale Of Lower-Tier CFCs Sale Of Lower Tier CFCs

FACTS:

• CFC 1 is organized in Holland and owns 100% of

CFC 2.

• CFC 2 is organized in France and pays tax there at

ff i f 33%

USCO

an effective rate of 33%.

• CFC 1 sells the stock of CFC 2 at a gain and pays

no Dutch tax on that gain. RESULTS

100%

Buyer

CFC 1 (H ll d)

RESULTS:

• CFC 1’s gain on the sale of stock in CFC2 is

FPHCI under §954(c) and is includible in USCO’s income under subpart F.

Buyer sells stock of CFC 2

(Holland)

100%

income under subpart F.

• Sect. 964(e) treats the gain on the sale as if §1248

treated the gain as a dividend. This deemed dividend may be subpart F income. See §954(c)(6)

CFC 2 (France)

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• USCO receives a §902 deemed paid credit under

§ 960(a)(1) for taxes paid by CFC2 in France.

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Previously Taxed Income (PTI) And Tax Basis

O S b t F i i t d it b PTI

• Once Subpart F income is taxed, it becomes PTI.
• PTI can be distributed at any time without any tax consequences. §959(a)

– Ordering rules apply, so that PTI comes out of a CFC before taxable dividends do.

• In addition, Subpart F income increases the basis of the stock in the CFC.

§961(a)

• Once PTI has been distributed, the basis in the CFC stock is reduced. §961(b)
• Similar PTI rules apply to §1248(a) and §956 inclusions

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• Similar PTI rules apply to §1248(a) and §956 inclusions.

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Additional Points

• Subpart F income and §956 income carry out a proportionate share of E&P and

f i di d foreign tax credits under §902. See §960

• Subpart F income and §956 income do NOT qualify for the reduced rate of tax
• n dividends in the hands of individuals; they are not “dividends” under

§1(h)(11) .

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Andrew Mitchel, Andrew Mitchel LLC

SELECTED TYPES OF SUBPART

Andrew Mitchel, Andrew Mitchel LLC Davis Wang, Sullivan & Cromwell

F INCOME

Types Of FPHCI Types Of FPHCI

• Dividends, interest, royalties, rents and annuities
• Gains on sales or exchanges of certain property

G i diti

• Gains on commodities
• Foreign currency gains
• Income equivalent to interest

Income equivalent to interest

• Income from notional principal contracts
• Payments in lieu of dividends
• Personal service contracts

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Look-Thru Rule And “Same C t ” E ti Country” Exception

• These two exceptions apply only to dividends, interest, royalties

d t and rents

• These exceptions are discussed later in the presentation.

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Royalties Royalties

• Active trade or business exception
• D

l

• Developer

 CFC develops, or acquires and adds, substantial value to property and regularly engages in such activities.

• Marketer

 Property licensed as a result of the performance of marketing functions by the CFC; and  Through its own employees, the CFC maintains and

• perates an organization that is regularly engaged in the

business of marketing, or marketing and servicing, the licensed property; and  The organization is substantial relative to the royalties (safe harbor: Active licensing expenses ≥ 25% of

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adjusted licensing profit).

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Rents Rents

• Active trade or business exception
• Manufacturer

 CFC manufactures, or acquires and adds, substantial value to property and regularly engages in such activities. p p y g y g g

• Marketer

 Property leased as a result of the performance of marketing functions by the CFC; and marketing functions by the CFC; and  Through its own employees, the CFC maintains and

• perates an organization that is regularly engaged in the

business of marketing or marketing and servicing the business of marketing, or marketing and servicing, the leased property; and  The organization is substantial relative to the rents (safe harbor: Active leasing expenses ≥ 25% of adjusted leasing

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harbor: Active leasing expenses ≥ 25% of adjusted leasing profit).

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Rents (Cont ) Rents (Cont.)

• Active trade or business exception (Cont.)
• Real estate

 Through its own employees the CFC regularly performs  Through its own employees, the CFC regularly performs active and substantial management and operational functions with respect to the real property while it is leased.

• Idle property

 Property that is ordinarily used in active trade or business business  Leased temporarily during period when idle

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Gains On Property Sales Gains On Property Sales

• Includes:
• Gain on property that gives rise to dividends, interest,

royalties or rents y  E.g., stocks, bonds, licensed IP, rental real estate, etc.

• Gains on sales of partnerships, trusts and REMICs

 Special look through rule for 25% or greater owned  Special look-through rule for 25%-or-greater-owned partnerships

• Gain on property that does not give rise to any income

 E d l d l d t d id ll tibl  E.g., undeveloped land, unrented residence, collectibles, paintings, gold, etc.

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Gains On Property Sales (Cont.) Gains On Property Sales (Cont.)

• Excludes gains on:
• Inventory
• Tangible, depreciable, personal, property used in a trade or

business

• Real estate held for use in a trade or business
• Intangible property and goodwill used in a trade or business
• Assets that generate royalties or rents that meet the active
• Assets that generate royalties or rents that meet the active

trade or business exception  Gains on rental property (real estate, etc.) that meet the same country exception (discussed elsewhere) are not same country exception (discussed elsewhere) are not excluded from this category and would be FPHCI.

• Rule of thumb: Capital gains are FPHCI and ordinary gains are

not (this is not always true)

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not (this is not always true).

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Gains On Property Sales (Cont.) Gains On Property Sales (Cont.)

• Special rules
• Change in use

 E g change from undeveloped land held for investment  E.g., change from undeveloped land held for investment to subdivided land held as inventory  Look to use of property for >50% of period held

• Dual character property
• Dual-character property
• Losses on sales of property that would be FPHCI if sold at a

gain can offset current year FPHCI gains on sales of other property property.

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I. Introduction

Foreign Base Company Services Income

A. General rule: This category includes income derived by a CFC from certain services performed for, or on behalf of, a related person outside of the CFC's country of related person outside of the CFCs country of

• rganization.

B. Purpose: To deny tax deferral when isolating services income in a low-tax j urisdiction C. Any item of income that falls within the definition of FPHCI will be treated as FPHCI instead FPHCI is still FPHCI will be treated as FPHCI instead. FPHCI is still S ubpart F income, but certain exceptions (e.g. the same country exception) apply differently depending on whether an item of income is FPHCI or foreign base whether an item of income is FPHCI or foreign base company services income.

30

II. Basic rules

Foreign Base Company Services Income (Cont.)

A. Type of services: Very broad - “ technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services” B. “ For, or on behalf of, a relat ed person” (§1.954-4(b)) 1 Th CFC i id i b d b i l d f bli ti t th i 1. The CFC is paid or reimbursed by, is released from an obligation to, or otherwise receives substantial financial benefit from, a related person for performing services. 2. The CFC performs services that a related person is, or has been, obligated to f perform. 3. The CFC performs services in relation to property sold by a related person, and the performance of such services constitutes a condition or material term of such sale. And; 4. The CFC receives substantial assistance furnished by a related person in the performance of the CFC's services. C. S ervices performed out side t he CFC’s count ry of organizat ion 1 Place where services are performed: Facts-and-circumstances test usually where 1. Place where services are performed: Facts-and-circumstances test, usually where the persons performing the services are physically situated rather than the place where the services are utilized or consumed. §1.954-4(c)

31

Foreign Base Company Services Income (Cont.)

III. “ Related” generally means 50%

• f vote or value (in the case
• f corporations), or 50%
• f value of beneficial interests in a

partnership or trust. §954(d)(3)

• IV. Exceptions

A. Certain activities are excluded from foreign base g company service income. 1. Pre-sale services (e.g., marketing service)

§954(e)(2)(A) §954(e)(2)(A)

2. Offers to sell §954(e)(2)(B)

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I E i T FBCI Important Exceptions To FBCI

I. “ S ame country” exception II L k th h II. Look-through III. De minimis rule IV Full inclusion rule

• IV. Full inclusion rule

V. High-tax exception

• VI. Active finance-type income exceptions
• VI. Active finance type income exceptions

33

S C E i

I. “ S ame country” exception §954(c)(3)

Same Country Exception

A. Dividend and int erest 1. Interest and dividends received from a related corporation are excluded from FPHCI if the payer has a substantial part of its assets situated in the same country in which both it and the CFC are created or organized. B. Rent s and royalt ies 1. For rents and royalties, the exception does not require the payer to be incorporated in the same country as the CFC. Rent and royalties are excluded from FPHCI if received from a related party that is a corporation for the use of property FPHCI if received from a related party that is a corporation for the use of property in the recipient's home country. C. This exception does not apply to items that reduce S ubpart F income, because it would

• therwise be possible to shift S

ubpart F income to other related person while reducing the total amount of inclusions of S ubpart F income by the U.S . shareholder. §954(c)(3)(B) the total amount of inclusions of S ubpart F income by the U.S . shareholder. §954(c)(3)(B) 1. This exception to the exception generally does not apply to dividends, because dividends would not be deductible to the dividend payor. D. This exception will not apply to any dividend with respect to any stock which is tt ib t bl t E&P f th di t ib ti ti l t d d i i d d i attributable to E&P of the distributing corporation accumulated during any period during which the person receiving such dividend did not hold such stock, either directly or

• indirectly. §954(c)(3)(C)

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§954(c)(3)(B): Limitation On Same Country Exception

USP CFC1 ( t X) CFC2 ( t X) (country X) (country X)

rent 1. CFC1 has FBCI, but CFC1 pays to CFC2 significant amounts of rent for offices in country X. CFC1 has a substantial part of its assets in country X. 2. CFC2 is denied the benefits of the same country exception, because the

35

C C s de ed t e be e ts o t e sa e cou t y e cept o , because t e payments to it reduce CFC1’s subpart F income, and the total amount of Subpart F inclusions by USP would also be reduced if the exception were allowed.

L k Th h R l

II. Look-through §954(c)(6)

Look‐Through Rule

A. General rule: A look-through rule applies to dividends, interest, rents and royalties received by a CFC from a related CFC, as long as the amounts are attributable and allocable to neither S ubpart F income nor ECI. B. Rat ionale: §954(c)(6) operates such that active income of a payor CFC will not be t ransformed into S ubpart F income when payo C C w ll ot be t a s o ed to S ubpa t co e w e received by a related CFC in the form of a dividend or other passive income. C Cross-border payment s: The exceptions covers cross-border C. Cross border payment s: The exceptions covers cross border payments, unlike the “ same country” exception. D. “ Related” , when? At the time the dividend is received. E. S unset provision: This exception is currently set to sunset at the end of 2011.

36

L k Th h R l (C )

G. Anti-abuse (Notice 2007-9)

Look‐Through Rule (Cont.)

1. Avoidance of §956: If a dividend reduces or eliminates the applicable earnings of a CFC within the meaning of

§956(b)(1), such that it reduces a U.S

. shareholder's inclusion pursuant to §951(a)(1)(B), then the dividend is not eligible for the §954(c)(6) exception. 2. Change of character of income through the use of a conduit . C a ge o c a acte o co e t

• ug t e use o a co du t

entity: When a transaction changes the character of the underlying income and is effected through the use of a conduit entity, and a principal purpose for the use of the conduit entity is to qualify the underlying income for the

§954(c)(6) exception, then the dividends, interest, rents or

royalties received or accrued will not be treated as being received or accrued from a related CFC. Therefore, they will not be eligible for the §954(c)(6) exception.

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D Mi i i R l De Minimis Rule

III. De minimis rule If CFC l d i i i t f FBCI ( d If a CFC earns only a de minimis amount of gross FBCI (and gross insurance) income during a year, no part of the CFC's gross income for the year will constitute FBCI. The de minimis rule applies for a taxable year if the sum of the gross FBCI of a CFC for the year is less than the lesser of: (i) 5%

• f its gross income, or (ii) $1 million. §954(b)(3)(A)

(i) 5%

• f its gross income, or (ii) $1 million. §954(b)(3)(A)

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F ll I l i R l Full Inclusion Rule

• IV. Full inclusion rule

Th l id th t if th 70% f CFC' The rule provides that if more than 70%

• f a CFC's gross

income for a year consists of FBCI, then all of the CFC's gross income for the tax year is treated as FBCI. Under this rule, income not otherwise subj ect to S ubpart F becomes S ubpart F

• income. §954(b)(3)(B)

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Hi h T E i High‐Tax Exception

V. High-tax exception A it f FBCI ( i i ) b l d d f An item of FBCI (or insurance income) may be excluded from S ubpart F income if it is subj ect to an effective rate of foreign income tax greater than 90%

• f the maximum U.S

. corporate

• tax. §954(b)(4)

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Active Finance‐Type Income Exceptions

VI. Active finance-type income exceptions A. Banking and financing Income: FPHCI does not include qualified banking or financing income of the CFC. Therefore, any income that otherwise falls within the definition of FPHCI – e.g., dividends, interest, rents, royalties and gains – will not be FPHCI to the extent this exception applies. §954(h) B. Insurance income: FPHCI does not include qualified insurance income of a qualifying insurance company. This exception generally applies to certain investment income derived by a CFC engaged in the active conduct of an insurance business. §954(i) C. Except ions for dealers: An exception to the definition of FPHCI is provided for dealers in property and dealers in securities. p p p y

§954(c)(2)(C)

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I I U S P § 6

I. Introduction

Investment In U.S. Property §956

A. General rule: A U.S . shareholder is taxed on the shareholder’s pro rata share of any increase in the earnings

• f the CFC invested in U S property
• f the CFC invested in U.S

. property. B. Purpose: To deter U.S . taxpayers from repatriating (through loans and other investments) earnings of a CFC in a tax-free manner, when the earnings have not been subj ect to U.S . tax. Not e: §956 applies to non-FBCI E&P of the CFC as well.

§

pp C. The effect : U.S . shareholders are treated as if the purchase price for the U.S . property had been distributed to them as a cash dividend and then cont ributed back to the CFC to cash dividend and then cont ributed back to the CFC to purchase the property, although the analogy is not exact.

42

II.

Basic rules

Investment In U.S. Property §956 (Cont.)

A. “ U.S . propert y” : Any property that is tangible property situated in the U.S ., any security issued by a U.S . payor, or the right to use in the U.S . certain intangible properties B. Amount of investment is determined by reference to basis rather than FMV . C Except ions C. Except ions

• U.S

. government obligations

• Money and bank deposits
• The stock/ debt obligations of “ third-party” U.S

. corporations g p y p

• For this purpose, a “ third party” U.S

. corporation is a U.S . corporation that is neither a “ U.S . shareholder” of the CFC or a domestic corporation that is at least 25%

• wned (by vote) by “ U.S

. shareholders” of the CFC. Assets equal to the earnings of the CFC that have been taxed as effectively connected

• Assets equal to the earnings of the CFC that have been taxed as effectively connected

with the conduct of a U.S . TOB D. Trade receivables: U.S . property also includes any “ trade or service receivable,” if the receivable is acquired from a relat ed U.S . person and is the obligation of a U.S . person. This means that most export receivables of a related U S person may still be acquired by a CFC means that most export receivables of a related U.S . person may still be acquired by a CFC without the acquisition being treated as an investment in U.S . property.

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Investment In U.S. Property §956 (Cont.)

E. Typical sit uat ions 1. Loans made by the CFC to a U.S . related company 2 P h b th CFC f t k i l t d U S 2. Purchase by the CFC of stock in a related U.S . company 3. CFC invests its earnings for use in its U.S . business g

• perations.

4. CFC licenses intangible property to a U.S . related company for use in the U S company for use in the U.S . 5. The guarantee by a CFC of the debt obligation of a related U.S . corporation

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F . Pledges and guarant ees by a CFC

Investment In U.S. Property §956 (Cont.)

g g y 1. A guarantee by a CFC of the U.S . parent loan is treated as investment in U.S . property. 2 I f the parent borrows money pledging the stock of the CFC 2. I f the parent borrows money pledging the stock of the CFC, there would be no adverse tax consequences, unless two-thirds

• f the voting stock is pledged and there are negative covenants

preventing the disposition of assets by the CFC. 3. Rat ionale for t he 2/ 3: Apparently based on the assumption that if the lender acquired the pledged stock upon the borrower's default, it would normally own sufficient voting power to enable it to liquidate the CFC and obtain a pro rata portion of its underlying assets G. End-of-quart er “ snapshot ” rule: The amount of investment in U.S . property is determined by reference to the assets held by the CFC at the close of each quarter.

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I. Previously t axed income (PTI): Inclusion does not reduce E&P but gives rise t PTI

Investment In U.S. Property §956 (Cont.)

to PTI. J. Rule applicable to partnerships (§1.956-2(a)(3)): If a CFC is a partner in a partnership that owns property that would be U.S . property if owned directly by the CFC, the CFC will be treated as holding an interest in the property by the CFC, the CFC will be treated as holding an interest in the property equal to its interest in the partnership, and such interest will be treated as an interest in U.S . property. Ant i-abuse rules 1.

• Temp. Regs. §1.956-1T(b)(4): Designed to prevent a CFC from using

another person or entity in order to make an investment in U.S . property in a manner that avoids §956 2 C d i ( b k b k d i A U S 2. Conduit arrangements (e.g., back-to-back deposit: A U.S . parent may not be able to avoid §956 if it arranges for the CFC to deposit funds in a bank, and for the bank to loan an equivalent amount to U.S . parent). 3. Adj usted basis of property acquired in certain non-recognition 3. Adj usted basis of property acquired in certain non recognition transaction §1.956-1(e)(6) (denial of attempt to argue for zero stock basis)

46

§ 6 ( )(6) §1.956‐1(e)(6)

USP USP US1 US2

1 US2 i $100 f it t k t CFC i h f $10 f CFC t k d $90

CFC

1. US2 issues $100 of its stock to CFC in exchange for $10 of CFC stock and $90 cash. 2. US2’s transfer of its stock is subject to §351. 3. US2 recognizes no gain under §1032(a).

47

4. CFC’s basis in the US2 is determined under §362(a). 5. Regulations deny $0 basis in US2.

Subpart F Impact From Sale Of Subsidiaries

Whether a CFC subsidiary checks the box affects character of gain on sale (even though the check the box election has no relevance to local law). A. In general, gain realized by a CFC on the sale of stock in a lower-tier CFC i FPHCI d lt i S b t F i l i CFC is FPHCI and may result in S ubpart F inclusion. B. However, gain from the sale of assets used in an active trade or business generally does not result in S ubpart F inclusion. §1.954-2(e)(3) C. S imilarly, a look-through rule applies to sales of 25%

• r greater

partnership interests. §954(c)(4) D. From a U.S . tax perspective, it might be desirable to check-the-box of the lower tier CFC The IRS attacked the pre transfer branch election in the lower-tier CFC. The IRS attacked the pre-transfer branch election in Dover Corp. v. Comr., 122 T .C. 324 (2004). However, the court found that the disregarded entity election was effective immediately before the sale, and therefore the gain was not S ubpart F income even though the lower-tier CFC’s assets were not actually used by its parent.

48

COMPLIANCE AND

Andrew Mitchel, Andrew Mitchel LLC

REPORTING ISSUES

FBCSI FBCSI

• Requirements

1. CFC purchases from related person or sells to related person (or purchases or sells on behalf of related person). p ( p p ) – The “branch rules” can deem a purchase and/or sale as being on behalf of a related person. 2 The property was not manufactured in the CFC‘s country 2. The property was not manufactured in the CFC s country

• f incorporation.

3. The property was not purchased or sold for use in the CFC’s country of incorporation And CFC s country of incorporation. And,

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FBCSI (Cont.) FBCSI (Cont.)

• Requirements (Cont.)

4. The property was not manufactured by the CFC. – The CFC does not meet the “physical manufacturing The CFC does not meet the physical manufacturing test.” » Substantial transformation (through the activities

• f the employees of the CFC)
• f the employees of the CFC)

» Substantive manufacturing (20% safe harbor or substantial in nature and generally considered manufacturing) manufacturing) – The CFC does not meet the “substantial contribution test.”

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FBCSI (Cont.) FBCSI (Cont.)

• Substantial contribution test
• The CFC makes a substantial contribution through the activities of its

employees to the manufacture of the personal property. p y p p p y

• Indicia of manufacturing:

 Oversight and direction of the manufacturing activities  Performance of some manufacturing activities  Material selection, vendor selection, or control of the raw materials, WIP or finished goods  Management of manufacturing costs or capacities e.g., managing the risk of loss, cost reduction or efficiency e.g., managing the risk of loss, cost reduction or efficiency initiatives associated with the manufacturing process, demand planning, production scheduling, or hedging raw material costs  Control of manufacturing related logistics  Quality control  Quality control  Developing, or directing the use or development of, product design and design specifications, as well as trade secrets, technology or other IP for the purpose of manufacturing, producing or constructing the l

52

personal property

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FBCSI (Cont.) FBCSI (Cont.)

• Manufacturing branch rule
• The CFC (including its branches) must manufacture personal

property.

• The manufacturing activities must take place outside the CFC‘s

country of incorporation.  S i l l d i h l i f f i  Special rules to determine the location of manufacturing

• If a tax rate disparity exists, then purchasing or selling income

earned in a location other than the manufacturing location is deemed to be earned on behalf of a related person (where the deemed to be earned on behalf of a related person (where the manufacturing branch is treated as the related person).

• A tax rate disparity exists if the tax rate on the purchasing or selling

income at the location of the purchasing or selling activities is at p g g least 5 percentage points less than, and less than 90% of, what the tax rate would have been in the manufacturing location on the same income.

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FBCSI (Cont.) FBCSI (Cont.)

• Sales branch rule
• Only applies if the manufacturing branch rule does not apply
• The CFC (including its branches) must carry on purchasing
• r selling activities outside the CFC’s country of incorporation.

g y p

• If a tax rate disparity exists, then the purchasing or selling

income is deemed to be earned on behalf of a related person (where the CFC itself is treated as a related person separate ( p p from the purchasing or selling branch).

• A tax rate disparity exists if the tax rate on the purchasing or

selling income at the location of the purchasing or selling g p g g activities is at least 5 percentage points less than, and less than 90% of, what the tax rate would have been in the home

• ffice of the CFC if the income had been earned by the home

54

• ffice.

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ANTICIPATING IRS AUDIT RED

Andrew Mitchel, Andrew Mitchel LLC

FLAGS

Form 5471 Form 5471

• The penalty for failing to file Form 5471 is generally $10,000
• The penalty is generally automatically imposed for U.S. corporations

(although it may be abated with reasonable cause).

• Categories of filers
• A U S

b i th t f fil

• A U.S. person can be in more than one category of filer.
• In the closely-held context, it is not uncommon for the U.S. owner to

be a category 2, 3, 4 and 5 filer in the first year the CFC is formed.

• For instance this scenario would arise where a U S individual:
• For instance, this scenario would arise where a U.S. individual:

 Acquires more than 50% of the shares of a CFC (Category 3),  Owns those shares for more than 30 days during the year (Category 4) (Category 4),  Owns those shares on the last day of the CFC’s year (Category 5), and  Is an officer or director of the CFC (Category 2).

56

Is an officer or director of the CFC (Category 2).

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Form 5471 (Cont.) Form 5471 (Cont.)

• Category 3 filers
• There is a separate $10,000 penalty for failing to complete

the information required on Schedule O (Code §§6046(f), 6679).

• If the U.S. person is a Category 3 filer, other forms or

disclosures are often required.  See Form 926 & additional disclosures under Code §6038B  If the CFC was a party to a reorganization, then additional disclosures may be required under Code §367 y q § and 368 (see, for instance, Treas. Reg. §§1.367(b)-1(c) and 1.368-3).

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Form 5471 (Cont.) Form 5471 (Cont.)

• Subpart F Income of the CFC is reported on Schedule I of Form

5471.

• For individual U.S. shareholders, their pro rata share of Subpart

F Income is included on Form 1040, line 21 (other income).

• For corporate U.S. shareholders, their pro rata share of Subpart

F Income is included on Form 1120, Schedule C, line 14.

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Form 5471 (Cont.) Form 5471 (Cont.)

• Dividends
• Non-PTI dividends received by a U.S. shareholder are

reported on Schedule I, line 7. p ,

• Non-PTI dividends paid by the CFC are reported on

Schedule M, line 21.

• PTI and non-PTI dividends paid are reported on Schedule J
• PTI and non PTI dividends paid are reported on Schedule J,

lines 5a and 5b.

• Exchange gain or loss on PTI dividends are reported on
• Exchange gain or loss on PTI dividends are reported on

Schedule I, line 8.

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IRS Red Flags IRS Red Flags

• The income statement on Form 5471 (Schedule C) shows

dividends, interest, royalties, rents or capital gains in excess of 5% of gross income, or in excess of $1M.

• Subpart F Income unless one of the exceptions applies.
• Unexplained large changes in retained earnings or other equity

accounts

• Incomplete or inconsistent schedules on Form 5471
• No Schedule O attached when required

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Disclosure

This slide set does not constitute an opinion. Thus, the use of the terms “is ” “will ” “should ” or similar terms are not meant to convey an opinion is, will, should, or similar terms are not meant to convey an opinion

• n the tax consequences of the discussed transactions. If you request

an opinion, the appropriate opinion level with respect to the transactions must be determined based on a further analysis of the facts and i t f t l i l t ti d ft li ith circumstances of an actual implementation, and after compliance with internal control procedures of Andrew Mitchel LLC. T l ith U S IRS l ti d i th t t d i To comply with U.S. IRS regulations, we advise you that any tax advice included is not intended or written to be used, and it cannot be used (i) to avoid any penalties under U.S. federal or state income tax law that may be imposed by any U.S. or state governmental taxing authority or agency p y y g g y g y

• r (ii) to promote, market or recommend to another party any transaction
• r matter addressed herein.

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TAX PLANNING INVOLVING

Sam Kaywood, Alston & Bird

SUBPART F

U.S. Drivers

F i di l i

• Foreign tax credit planning

– Avoid double-tax – OFL planning b h d – Debt push-down

• Deferral

– Avoid Subpart F

• APB 23
• Cash management

– Where do we need the cash?

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Overall Strategy gy

U.S. Bank

Loan USCo

Intermediate Jurisdiction

Holdcos/ SPVs Equity Opco Debt

Source Country

p

Country

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Check-The-Box Strategy

U.S. Parent

Th 2009 Ob b d

• The 2009 Obama budget

proposed to limit these structures.

Holdco (Holland)

100% Royalties

IP License Co Other UK Opco France Opco IP License Co (Belgium) European Opcos

UK Customers French Customers European Customers

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Subpart F Check-The-Box

• A successful check-the-box election

would achieve two purposes: (1) The sale of stock (normally falling under Subpart F) would be

U.S. Parent

treated as a sale of assets (not falling under Subpart F). (2) The deemed sale of asset would

Buyer CFC1 (Holland)

Sell CFC2 stock

produce foreign source income in the “active” rather than “passive” basket, for foreign tax credit purposes

CFC2 (Germany)

purposes.

(Germany)

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• Taxpayer won this case in Dover v. Commissioner.

§954(c)(6) Exception

• FPHCI excludes dividends,

, interest, rents and royalties from related persons during 2006, 2007, 2008 and 2009. See

USCo

§954(c)(6)

• N/A to interest, rents and

royalties allocable to Subpart F

HoldCo (Lux)

income of payer or to U.S. “effectively connected income.”

Dividends IP/Finance (Belgium) Interest Royalties Foreign Opco (Asia)

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67

Holding Company Jurisdictions: Types Of Jurisdictions Types Of Jurisdictions

High-Tax Jurisdictions Tax-Haven Jurisdictions Tax-Friendly Jurisdictions Jurisdictions

• High-tax rates
• CFC rules
• Not good for holding

Jurisdictions

• Totally tax-free
• No tax treaties

C Jurisdictions

• No tax on capital gains and

dividends

• Good for holding
• Not good for holding

companies

• U.S., U.K., Germany,

France, China

• Cayman
• Bermuda
• BVI

A ti t h l

• Good for holding

companies

• May have capital duties
• Can be good for interest

,

• Anti-tax haven rules -

e.g., Brazil, Mexico Can be good for interest and royalties

• Good treaty networks
• Netherlands, Spain

p Luxembourg, Belgium, Switzerland

• Otherwise, high-tax

t i countries

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68

Holding Company Jurisdictions (Cont.) g p y ( )

• Luxembourg, Netherlands and Switzerland are all good as holding companies

– participation exemption for dividends and capital gains. – Lux and Netherlands are not good for tax haven subsidiaries, whereas Switzerland does not care.

• For IP licensing, Switzerland and Ireland are good, taxing royalties at 8% and

12.5% respectively, although tax planning are available to reduce rates further.

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Holding Company Jurisdictions: Types of Jurisdictions (Cont.) Types of Jurisdictions (Cont.)

• Hong Kong

– Dividends and capital gains are exempt Dividends and capital gains are exempt. – Good holding company jurisdiction for China

• Good treaty with China
• China challenging use of offshore holding companies to avoid Chinese

capital gains tax (Circular 698) – 17.5% corporate tax rate 17.5% corporate tax rate

• Foreign source income taxed at 50%

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Financing Structures: Use Of Hybrid Debt Use Of Hybrid Debt

• Lux HoldCo accrues “interest” on

Parent

PECs/CPECs to offset against interest income from Opcos.

Parent (US) PECs CPECs

• Can defer paying interest as long as

desired

Holdco (Lux) CPECs

• When paid, interest can be treated as

dividend for U.S. purposes, carrying

• t foreign ta credits

Opco Loans Interest

• ut foreign tax credits.
• APB 23 considerations

p Companies

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71

Financing Structures: Swiss Finance Branch Swiss Finance Branch

S i HoldCo (Lux) Swiss Finance Branch Loans Interest Opcos Opcos

• Pay corporate tax in Switzerland and Luxembourg on a small spread
• Need CHF100 million of debt for Swiss purposes

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72

BV/CV Structure

USP

U.S.: Non-transparent Dutch: Transparent Loan

CV BV

U.S.: Transparent Dutch: Non-transparent Loan U.S.: Transparent Opco: Either

European

Opco: Either

European Opcos

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