An American enterprise contemplating doing business abroad should select a structure which maximizes flexibility, minimizes tax (both foreign and domestic) and avoids complexity and cost inappropriate to the size of the enterprise. This paper is an introduction to structure selection.
I. Factors in Structure Selection
A. Local (foreign) law.
The laws of the foreign country in which a business is operated ("local law") will determine, in part, the entity selected. Many countries favor or require a corporation or other entity organized under local law. Even if there is no legal requirement, business considerations may favor a local entity. Some countries require that their citizens be given an opportunity to invest. The employer may wish to grant stock options to employees or provide some means for allowing local management to participate in the profits of the local company. Many countries frown on foreign ownership of real property. Some countries impose more onerous requirements on foreigners when issuing licenses or permits or contracting. Your customers or suppliers may prefer a local presence.
Most countries today offer a choice in business entities. There is usually an entity that corresponds to our notion of a corporation (in Latin America, a Sociedad Anonima or "S.A.") and an entity that corresponds to our notion of a "partnership" in which no partner has personal liability (i.e. a limited liability company) (in Latin America a Sociedad de Responsabilidad Limitada or "S.R.L."). There will often be non-tax consequences of choosing a form. For example, in Japan the Kabushi Kaisha or "K.K." (corporation) is more prestigious than the Yugen Kaisha or "Y.K"(limited liability company). The local taxation of an entity is not necessarily the same as ours. Check to see whether the corporate equivalent is a separate tax paying entity or the limited liability company is a pass through entity.
B. Movement of assets (the Constructive Dividend issue).
If there is more than one entity consider the United States tax consequences of moving assets among corporations. Mr. O owns two companies: JCO, KK in Japan and MCO, SA in Mexico. JCO transfers trade secrets and processes worth $10M to MCO. JCO's basis in this intellectual property is $0. Prior to the transfer JCO has no earnings and profits. The transfer will be treated as a distribution from JCO to Mr. O followed by a contribution by Mr. O of the intellectual property to MCO. The distribution causes JCO to recognize gain of $10M, Internal Revenue Code ("Code") Section 311. Putting aside for the moment the question of whether JCO or Mr. O (under Subpart F as discussed below) pays tax on that gain, it is at least true that the gain will cause an increase in earnings and profits of JCO, Code § 312(b). The distribution will be from these earning and profits and therefore be a dividend to Mr. O, Code § 316. Thus $10M is taxed to Mr. O, Code § 61(a)(7) at the ordinary (not capital gains) rates. This tax is imposed even though Mr. O never actually had possession of the asset.
Mr. O might have initially established USCO, Inc., a U.S. corporation. USCO might have become owner of JCO and MCO. The intellectual property would then move (or be deemed to move) from JCO to USCO to MCO. Mr. O would not be deemed to receive a dividend and therefore would owe no tax. However USCO would owe a full tax on the deemed dividend.
Note that in this case no dividend received deduction would be available to USCO. JCO is not a domestic (U.S.) corporation so Code § 243 is inapplicable. The dividend received deduction is applicable only to certain U.S. income of foreign corporations. Code § 245. Foreign corporations cannot be part of consolidated reporting groups. Code § 1504(b)(3). Thus dividends paid by a foreign corporation to a U.S. entity (sometimes referred to as ?crossing the line') are generally fully taxable. Mr. O should, at a minimum, have formed FCO, a foreign corporation to hold his JCO and MCO stock, to permit shifting assets from JCO to MCO without attracting tax under basic U.S. tax principles. FCO should, of course, be organized in a foreign jurisdiction which does not tax such transactions. We save for later the question of whether the transaction in the example attracts U.S. tax under Subpart F or withholding tax in Japan.
C. Treaties
The United States taxes foreigners on income effectively connected with the conduct of a trade or business in the United States, Code § 871(b) and 882. In many cases a second tax (or at least a tax) is levied on dividends, interest, rents, royalties or branch profits. Code Sections 871, 882 and 884. Many other countries follow suit and levy these second tier taxes. The United States has negotiated a set of Income Tax Treaties (mainly, but not exclusively, with industrialized nations) under Code § 894 providing in part that residents of one nation need not pay the second tier tax (or will pay a reduced rate) on passive income or branch profits derived from a treaty partner. Other nations have similar treaty networks. Returning to the first example, if JCO pays a dividend, it is subject to Japanese withholding tax. However, if JCO pays a dividend to USCO, the withholding tax will be reduced to 10% (in this case). U.S.-Japan Income Tax Treaty (1972), Article 12(2)(b), 86 TNI 8-27; TIAS 7365. However if JCO pays a dividend to FCO, the U.S.- Japan treaty will not apply. Therefore in selecting a country in which to organize FCO, consideration should be given to that country's treaty network.
D. Foreign Tax Credit
1. In general. The United States permits U.S. taxpayers to take certain foreign tax payments as credits against U.S. tax liability. Code Section 27(a). Generally only income taxes, Code § 901(b) or taxes paid in lieu of income taxes, Code § 903 are creditable. If USCO owns at least 10% of the stock of FCO it may take a credit for taxes paid by FCO on a "deemed paid" basis. Code § 902. The deemed paid credit is available for taxes paid by subsidiaries down to the sixth tier, Code § 902(b)(2)(iii). USCO includes in income the dividends actually received together with the taxes deemed paid, Code § 78.
2. Limitations. The credit is subject to complex limitations under Code § 904. The basic idea is straight forward. Suppose USCO pays taxes at a marginal rate of 35%. The credit on a particular item of income (after gross up under Code § 78) cannot exceed 35% of that income, i.e. you can only credit the amount that the U.S. would have taken in tax. Taxpayers never get this full amount.
First the credit is limited to the taxpayer's average tax rate, not its marginal tax rate, Code § 904(a). Next, in the case of corporations, income is separated into 9 "baskets" (types, such as passive income, high withholding tax income, dividends from noncontrolled corporations, etc.). The limit for crediting tax based on basket income is based only on the income from such basket. Code § 904(d). Next, losses sustained in prior years are used to reduce income earned in succeeding years for purposes of calculating the limitation, Code § 904(f). Finally, and perhaps most importantly, the limit is based only on foreign source income, Code § 904(a). The sourcing rules are found in Code § 861-65, regulations thereunder and elsewhere and are quite complex. For example if a taxpayer borrows in the United States allocation of the interest expense is made to reduce foreign source income since money is fungible. See Treasury Reg. 1.882-5.
3. Alternate Minimum Tax. If a taxpayer is subject to alternate minimum tax, the foreign tax credit is recomputed under Code § 59(a)
4. Planning. For planning purposes, it may be possible to transfer income from one basket to another, change timing to reflect loss recapture, change sourcing of income, change timing of income (so the credit is available in a year when the taxpayer has a higher average rate), mix foreign income (bring more foreign income into FCO from MCO so that the credits for taxes paid by JCO to Japan can be used) or reduce the AMT. While the techniques to do this are well beyond the scope of this paper this process is facilitated by having one or more (usually at least two tiers) FCOs.
E. Losses
A taxpayer would prefer a current deduction for foreign (or any other) losses. This may be facilitated by having no intermediate entities, or having a pass through entity (limited liability company). Ideally a taxpayer might desire a foreign entity that would pass through losses and then change form so that future income did not pass through. The Code attempts to prevent this, Section 367(a)(3)(C), although this provision may not cover all cases. In planning for loss use, remember that losses usually cannot be deducted in excess of basis Code § 704(d) and 1366(d), may be limited to the amount "at risk", Code § 465 and may be subject to the Passive Activity Rules, Code § 469. If losses are substantial, net operating losses to corporations are sometimes more valuable than those passing through to individuals because under Code § 172 the individual uses her losses against low bracket income (already reduced by non business deductions) and wastes the loss to the extent of personal exemptions. Code § 172(d)(3).
F. Out Bound Transactions
1. Transfers of Property to Corporations In General. The most general rule is that transfers of appreciated property to an entity in return for an ownership interest in the entity creates taxable gain, Code § 1001. Two exceptions are so broad as to make us forget the general rule. With minor exceptions transfers of property to a partnership are not currently taxed Code § 721. Similarly transfers of property to a corporation are not currently taxed if the transferors own at least 80% of the corporation immediately after transfer, Code § 351. However Section 351 has numerous exceptions.
2. Transfers to Foreign Corporations. Generally transfers to foreign corporations are taxable because under Code § 367(a) the transferee is not considered a corporation, making Code § 351 inapplicable (and the gain recognition rule of Section 1001 applicable). Transfers of foreign or domestic stock to a foreign corporation in many cases ARE taxable, but see Treasury Regulation 1.367-(a)(3) when foreigners maintain control. This means once the value of JCO or MCO stock has appreciated Mr. O may transfer the stock tax free to USCO (not the desired result) but if either Mr. O or USCO transfers the stock to FCO, there will be tax. This puts a premium on forming FCO as early as possible. On the other hand it is usually possible to transfer JCO stock from FCO to a foreign subsidiary of FCO without gain recognition. Treasury Regulation 1.367(b)-4.
3. Incorporating an existing business. If a U.S. business is transferred to a foreign entity gain is recognized, Code § 367(a)(1), but a foreign business may be incorporated as a foreign corporation without gain recognition Code § 367(a)(3) subject to taxation of previously deducted losses, accounts receivable, depreciation in excess of actual decline in value and similar items.
4. Intangibles. If an intangible is transferred by a U.S. person to a foreign corporation in a tax deferred transaction, the transferee includes annually in income the amounts the transferor receives, Code Section 367(d). Thus income from intellectual property is generally taxed currently in the United States even though the asset has been transferred to a foreign corporation.
5. Transfers to Trusts. Transfers of appreciated property to foreign trusts (other than grantor trusts) also trigger gain, Code § 684.
G. Deferral
1. Taxation of Foreign corporations In General. Perhaps the major goal of tax planning is the deferral of tax on income earned abroad to such time as the taxpayer chooses to repatriate it. Moline Properties, Inc., 319 U.S. 436 (1943) is often cited for the proposition that a corporation is legally distinct from and therefore, absent specific statutory provision, taxed without reference to, its shareholders. Therefore a foreign corporation that is not engaged in business in the United States and has no U.S. source income would not be subject to U.S. Tax, Code § 881(a), 882(a) and see 884((a),(b) and(d). The tax is deferred until the income is repatriated. There are a number of exceptions to this rule.
2. Controlled Foreign Corporations. The most comprehensive exception is Subpart F, discussed in more detail below, which provides present inclusion in the income of a U.S. person owning (or deemed to own) at least 10% of the stock of a foreign corporation (a "U.S. Shareholder") of certain income ("Subpart F Income") of the corporation and its subsidiaries if U.S. Shareholders own at least 50% (measured both by control and value) of the company ("CFC").
3. Section 1248. Related to Subpart F is Code § 1248 which converts what would otherwise be capital gain on the sale of shares of a CFC into dividend income, roughly to the extent of the untaxed earnings of the CFC.
4. Foreign Investment Companies. A somewhat similar provision in Code § 1246 and 1247 turns capital gain on the sale of stock of a foreign investment company ("FIC") into ordinary income . The provision only applies if at least 50% of the shares are held by U.S. persons and the entity is registered under the Investment Company Act of 1940.
5. Foreign Personal Holding Companies. The foreign personal holding company ("FPHC") rules, Code § 551-558 provide for current inclusion in income of certain passive income if 5 or fewer individuals own more than 50% of the company and initially 60% of the income is passive or personal service income. Most FPHCs are CFCs and Subpart F trumps, Code § 951(d). However consider a foreign corporation 49% owned by A, 9 % owned by B, C, D, E and F and 6% owned by G, all U.S citizens not related to one another. The entity is not a CFC as only A is a United States Shareholder (10% or more ownership), but if the passive income requirements are met, is a FPHC.
6. Passive Foreign Investment Companies. Section 1291-1297 of the Code deal with Passive Foreign Investment Companies ("PFICs"). A PFIC is a foreign corporation which has either 75% passive income or 50% of its assets producing passive income. The latter rule extends the PFIC regime to entities that may look like active businesses but have few hard assets (say a sales or service company) and have reinvested earnings in passive assets. Any U.S. shareholder of a PFIC (regardless of size of ownership or total U.S. ownership) must either report her share of PFIC income currently, or pay an interest charge on deferred income when paid.
7. Excess Passive Investments (Repealed). Between its enactment in 1993 and its repeal in 1996, Section 956A provided that if a CFC invested non Subpart F earnings in passive assets (above 25% of total assets) (the "Excess Passive Asset Rule") such earnings would be included currently in a U.S. Shareholder's income up to the value of the excess assets. This provision was repealed, so that this sort of deferral is possible.
H. Some Current Deferral Opportunities
A foreign corporation that is not a CFC, FIC, FPHC or PFIC can defer tax on its income indefinitely. A CFC can defer tax on its non- Subpart F income indefinitely.
A CFC can reinvest its tax deferred income in passive assets that yield little passive income (many companies pay dividends of 1% or less on their shares) and the appreciation on such assets is deferred (repeal of Code § 956A).
Currently income from the active conduct of an insurance, banking or financing business is not Subpart F income. Code § 954(h) and (i).
What would otherwise be Subpart F Income can be turned into Non-Subpart F income using hybrids as discussed below. If these deferral opportunities are available, they may affect the choice of entity.
I. State tax issues
Many states of the United States impose income tax by apportioning the world wide income of a unitary business based on some combination of payroll, property and sales. Often wages, property values and sales price will be higher in a state than in a foreign company, which will result in foreign income being apportioned to and taxed in a state. However not all businesses are unitary and foreign corporations may be allowed to report on a "water's edge" basis (foreign source income not apportioned). Sometimes an "80-20" test is used, that is a corporation with 80% of its assets, payroll or sales (or some combination) outside the United States may be permitted to report on a water's edge basis.
Dividend income of a U.S. company may not be apportioned, but taxed only in the "home" jurisdiction. If United States and foreign operations are conducted by a U.S. corporation, interposing a United States corporation to hold shares in foreign corporations adds flexibility for dealing with state income tax. To give a simple example, suppose USCO is a Delaware corporation doing business in Utah owning FCO stock. Utah might contend that USCO has a commercial domicile in Utah. 59-7-302 UCA. In that case dividends paid by FCO to USCO are taxed in Utah, 59-2-309 UCA. If, however USCO owns USCO, International, a Nevada corporation with no contacts with Utah, which owns FCO, then a dividend from FCO to USCO, International is not taxed in Utah and Nevada has no corporate income tax. An alternate arrangement would be to make USCO a Nevada corporation owning FCO shares with a separately incorporated subsidiary to do business in Utah (commonly used if the company only does business in Utah).
J. Entity Issues.
At the beginning of the twentieth century state law drew major distinctions between a corporation and a partnership. Under current law there are no unalterable distinctions between these forms. Prior to the "check-a-box" regulations partnership attributes were chosen for tax purposes. These are no longer a factor in tax planning. Thus the distinctions that follow are generally without significance in selecting a U.S. entity, but may remain important under foreign law and in any event must be addressed in drafting documents.
1. Separate legal person. A corporation is a separate legal person. At common law a partnership was a form of reciprocal agency with the partners owning property as tenants-in-common. In the early twentieth century there was a major debate whether partnerships were entities or aggregates. For most purposes today partnerships have the attributes of entities.
2. Limited Liability. A corporation provides limited liability. An attempt was made to develop limited liability for partnerships with the limited partnership. This fell short of the mark because (I) there had to be at least one general partner without limited liability and (II) limited partners were often held to have lost their limited liability by participating in management. These problems are resolved by the limited liability company.
3. Free Transferability of Ownership. Corporate stock, in the absence of restrictions, is freely transferable, while the transfer of a partnership interest once dissolved the partnership. Today restrictions can be placed on stock transfer by shareholders agreements or in the articles or by-laws of the company, supported by legends on stock certificates to avoid rights vesting in bona fide purchasers. Partnership interests can be made freely assignable by so providing in the partnership agreement, 48-2a-702 UCA, though commonly the assignee takes a right to distributions but not a right to participate in management unless all other partners consent. 48-2a-704 UCA.
4. Continuity of Life. At common law a partnership was dissolved by all events that would terminate an agency: death, incompetence, bankruptcy, withdrawal by or expulsion of a member and the like. Today partnership agreements can provide the partnership will continue despite such events. Shareholder status and actions are not grounds for dissolving a corporation unless the articles or other organizing documents so provide.
5. Centralized Management. A partnership at common law could take action only with the agreement of all partners (although the power to act could be delegated). Limited partners were not allowed to participate in management. Today a limited liability company may be managed by members (essentially the partnership mode) or by managers, a flexible concept. Corporations are managed by directors who are elected by owners for a limited period of time, can be replaced, take action by majority vote and owe shareholders a fiduciary duty. However many states have close corporation statutes that permit corporations to be managed like partnerships.
II. Entities available
A. Domestic Entities
1. Tax Classification (basic).
The Internal Revenue Code recognizes four basic types of taxpayers:
a) Individuals. These are human beings, who, if married, may file jointly.
b) Partnerships. These are businesses (or in some instances investments) carried on by more than one person in which income and deductions pass through and are taxed to the partners.
c) Corporations. These are separate legal entities who pay tax themselves. Their shareholders pay tax on dividends and other distributions and recognize gain or loss on sale of shares.
d) Trusts. It is difficult to conduct business and be recognized as a trust. Trust classification is limited to arrangements for the protection or conservation of property. Entities classified as trusts generally deduct distributions made to beneficiaries, who pay tax on distributions to the extent of distributable net income ("DNI"). Trusts pay tax on undistributed DNI.
e) Nothings. Under the "Check-a-box" regulations Treasury Regulations 301.770 -1, -2 and -3. some legal entities owned by a single person are disregarded for tax purposes. The income is taxed directly to the single owner. For convenience such entities are sometimes referred to as "nothings."
2. State law classification and other tax classifications.
Most states now recognize a variety of entities.
a) Sole Proprietorship. This is a single individual conducting business in her personal capacity. The individual is fully liable for debts of the business. She is taxed as an individual.
b) General Partnerships ("GPs"). These are associations of two or more persons to carryon as coowners a business for profit, 48-1-3 UCA. All partners are jointly and severally liable. For tax purposes a general partnership is taxed as a partnership unless it elects to be taxed as a corporation.
c) Limited Partnerships ("LPs"). This is an entity with one or more General Partners who are jointly and severally (if more than one) liable for the debts of the business and one or more limited partners who, if they refrain from active management of the enterprise, are liable only to the extent of their investment and for obligations they explicitly assume ("limited liability"). Limited partnerships are taxed as partnerships unless they elect to be taxed as corporations.
d) Limited Liability Companies ("LLCs"). This entity has separate legal existence but under state law is not a corporation. Its members have limited liability. LLCs are taxed as partnerships if they have more than one member, nothings if they have one member or corporations if they so elect.
e) Limited Liability Partnerships ("LLPs"). Generally used by professionals, these entities consist of two or more persons who are general partners, except that by making a filing under state law the general partner is not liable for torts of his partners (e.g. malpractice) carried out in the course of the partnership business. The partner is liable for his own negligence or other torts. In Utah the partner is also liable for the contractual obligations of the partnership, UCA 48-1-12(2), but this is not true in all states. LLPs are taxed as partnerships unless they elect to be taxed as corporations.
f) Limited Liability Limited Partnerships ("LLLPs"). This is just an LP where the general partners (it doesn't really make sense if there is only one general partner) make the state filing described in e. above.
g) Joint Ventures. This is an arrangement of two or more persons to carry on a single business enterprise. For most purposes it is a kind of partnership, 48-1-3.1 UCA. Sometimes the parties try (not always successfully) to avoid being treated as a partnership for state or tax purposes. See 48-1-4 UCA. Under Code § 761(a) investors, exploiters of natural resources and securities dealers may elect out of partnership treatment so as to be treated as separate taxpayers holding property as tenants in common.
h) Trusts. Businesses may be conducted in trust form, sometimes called a Massachusetts Business Trust. This was more common in the late nineteenth century (hence the Sherman Antitrust Act). Usually legal title to property is conveyed to trustees to carry on business for profit. These will be taxed as partnerships or nothings unless they elect to be taxed as corporations. The trust form of business may be of more interest in foreign countries.
i) Corporations. These are separate legal persons formed under state or federal corporation (or similar) laws. Shareholders have limited liability. Corporations are taxed as corporations and may not elect to be taxed as partnerships or nothings.
j) "S" Corporations. This is a corporation that elects to be taxed as an S Corporation under the Code. S corporations must be domestic, and have only individuals (or estates or certain trusts) as shareholders. No nonresident alien may be a shareholder (but consider a partnership between an S corporation and a non-resident alien, Rev. Rul. 94-43). There may be no more than 75 shareholders, Code § 1361(b). S corporations are usually not taxed, but pass through earnings and deductions to their shareholders. Unlike a partnership, borrowing by an S corporation does not increase shareholders' basis, so that the limitation of deductions to a shareholder's basis is of greater concern. Corporations that elect S status after operating as C corporations may be taxed ( in addition to their shareholders) on built in gains (property which appreciated during the time the corporation did not have an S election), Code § 1374 and certain passive income. Code § 1375. Under current law S corporations may own some or all of the stock of a foreign corporation, but no foreign corporation can be treated as a nothing by an S corporation (in contrast to the rule for wholly owned domestic subsidiaries) Code § 1361(b)(3).
k) Personal Service Corporations. While this term is defined in the Code, see Section 11(b)(2), here it means that the corporation has sufficiently small capital that what would otherwise be income can be paid out as salaries, eliminating the corporate income tax (but not passing through losses). This entity is used by professionals in states where professional corporations are permitted but professionals (or some subset of them) are not ethically or legally allowed to use other limited liability vehicles.
B. Foreign Entities
Many foreign countries have some or all of the same entity options set forth above, or additional choices. Selecting among these will be important for local law purposes. For U.S. tax purposes, however, there are three basic choices.
1. Branch.
A United States entity doing business directly in a foreign country is referred to as a branch. Note that all recognized U.S. entities are taxable on their world wide income (including income from a foreign country), may deduct losses (subject to limitations) and qualify for the foreign tax credit (again subject to limitations). They may qualify for the benefits of a tax treaty between the host country and the home jurisdiction, however if they have a "permanent establishment" (a defined term which allows more than the "minimum contacts" under due process analysis) they will usually be subject to full taxation in the host country on host country income.
2. Corporation.
A foreign corporation (determined from the list set out in Treasury regulation 301.7701-2(b)(8)) will be taxed as foreign corporation (and may not elect partnership or nothing treatment.) Subject to the anti-deferral provisions discussed above, a foreign corporation is not taxed on foreign income until it is repatriated.
3. Partnership (and others).
All other business entities may elect to taxed either as a partnership (pass through) if there is more than one shareholder, a nothing if there is a single owner, or a corporation. The default rule, in the absence of an election, is the entity is a nothing if it has a single owner who does not have limited liability, a partnership if it has two or more members at least one of whom does not have limited liability and otherwise a corporation. Some practitioners suggest filing an election for every foreign entity to avoid disputes about the interpretation of this rule.
III. Subpart F
If a United States person owns at least ten percent of a Controlled Foreign Corporation ("CFC") Subpart F must be considered.
A. Subpart F Income
There are more than two dozen categories of Subpart F income. Three of the most important follow.
1. Foreign Personal Holding Company Income.
This includes dividends, interest, rent and royalties not derived by a CFC from the active conduct of a banking, finance or insurance business, Code Sections 954(c)(1)(A), 954(h) and 954(i), and similar passive income, subject to exceptions Code § 954(c)(1) and (2).
2. Foreign Base Company Sales Income.
If a corporation (the "CFC") organized in country X buys personal property manufactured outside of country X from another person ("Seller") and sells that property to another person ("Buyer") for sale outside of country X, and either the Buyer or Seller is related to the CFC, the CFC has foreign base company sales income, Code Sec 954(d)(1).
For example, USCO has three controlled foreign subsidiaries, ICO in Italy, GCO in Germany and LCO in Luxembourg. ICO manufactures widgets in Italy and sells at a low price to LCO, so ICO has little or no income subject to Italian income tax. LCO resells to GCO has at a high price, so GCO has little or no income subject to the German income tax on its German sales of widgets. Luxembourg does not tax the transaction at all. Subpart F taxes LCO's foreign base company sales income to USCO.
This is not as technical as it seems. Any company in the world manufacturing in one country and selling in another could interpose a base company in a country like Luxembourg that does not tax offshore transactions and avoid all (in this case Italian, German and U.S.) income tax. Further, LCO could sell the widgets to USCO at a high price, thus avoiding U.S. income tax on U.S. source income. In the extreme case, USCO could manufacture widgets in the United States, sell to LCO at a low price and repurchase at a high price, thereby avoiding income tax on a 100% U.S. transaction. Thus, Subpart F deals not with a technical loophole, but a practice that has the potential of rendering much of the U.S. income tax a nullity.
There are other ways of skinning this cat. Under Code § 482 and regulations promulgated thereunder, transfers between a foreign corporation and any related corporation must be at an arm's length price. While this prevents repeal of the U.S. income tax it leaves much opportunity for planning. Arm's length transfer prices cover a range, so that a taxpayer may select a high end or low end price. See Treasury Regulation 1.482-1(e). There are administrative issues: can the IRS discover abusive pricing on audit, can it prevail in litigation and is the cost of such activity commensurate with the benefit? Finally there are many ways of conferring value in the tax haven. For example if the trademark or trade name is owned by the tax haven entity (but see comments above on Code § 367(d)) substantial income will belong to that entity even at arm's length pricing.
3. Foreign Base Company Services Income.
This is much like Foreign Base Company Sales Income. If professional or management employees of the CFC perform services outside country X, for a related entity, the income will be Subpart F Income. Code 954(e)(1).
B. The Great Hybrid Controversy
1. What is a hybrid?
Under current law many foreign entities that are respected as separate legal entities under local law, U.S. non-tax law or even local tax law are (or may elect to be treated as) "nothings" for income tax purposes. It always take at least two entities to give rise to Subpart F Income. Dividends, interest and passive income are received from a different entity. A CFC does not receive interest from itself. The same is true for foreign base company sales and services income. Thus a CFC can create entities in any foreign legal jurisdiction (effectively, subsidiaries) and elect to have them disregarded for U.S. tax purposes. In the example above if GCO and ICO are "nothings" owned by LCO the sale of widgets from Italy to Luxembourg to Germany creates no Subpart F income. GCO and ICO are mere branches of LCO for U.S. tax purposes. The sale is disregarded. With careful planning Subpart F is avoided.
2. Notice 98-11.
To address this problem (and others) the Internal Revenue Service ("IRS) issued Notice 98-11 on January 16, 1998, 1998-6, I.R.B. 18. The IRS took the position that any payment within a CFC (between nothings) which reduced foreign tax potentially gives rise to Subpart F income. In February 1998 the Treasury proposed legislation to Congress that would have supported this position. (The inference might be drawn that existing legislation did NOT support this position.) On March 23, 1998, the IRS issued proposed and temporary regulations codifying this position. Treasury Regulation 1.954-9T.
3. Notice 98-35.
The proposed regulations aroused a storm of controversy in and out of Congress. On June 19, 1998 the IRS issued Notice 98-35, 1998-27 IRB 35 announcing its intention to withdraw Notice 98-11 and related regulations. On October 1, 1998, members of Congress proposed legislation prohibiting the Treasury from implementing Notice 98-35. After further controversy, on July 13, 1999 the 1998 regulations were replaced with regulations with a deferred effective date, Treasury Decision 8827, 64 Federal Register 58782. Under this proposal regulations will not be finalized before July 1, 2000, will not become effective until the taxable year of the CFC commencing 5 years after the finalization date and grandfathers arrangements existing on June 19, 1998 that are not substantially modified thereafter.
4. Reporting potentially abusive tax shelters.
In February of this year the IRS Issued Temporary Regulation 1.6011-4T(b)(2)(F) which identified this use of a hybrid as a potentially abusive tax shelter. As a result, if there is at least one more attribute suggesting an abusive tax shelter certain reports must be made by the applicable taxpayer to the Treasury. While the transaction is likely to be more closely scrutinized if reported, this requirement does not affect the legal merits.
5. Conclusion.
Under the law as it stands today, hybrids may be used to avoid Subpart F income. This statement is subject to multiple caveats. The position of the IRS may (is likely to?) change. Congress may change the law. Traditional tax doctrines of substance over form, step transaction, sham transaction, business purpose requirement and assignment of income may be used in traditional or novel ways to attack this problem. Other provisions of the Code such as Section 482 regulating transfer pricing or Section 367(d) regarding outbound transfer of intangibles may limit the benefits to be derived from hybrids.
IV. Some sample forms of organization
A. Minimum organization.
Form a U.S. LLC with foreign operations conducted through entities treated as partnerships or nothings. This will provide limited liability to the owner and may satisfy local law requirements. Losses and foreign tax credits will pass through, although their timing cannot be controlled. Deferral is NOT available. Since there are no corporations, constructive dividends are not an issue.
B. Conduct business through a foreign holding corporation.
This provides limited liability and the ability to comply with local law. Deferral IS available (subject to anti-deferral regimes). Foreign tax credits and losses will NOT pass through. As long at the foreign holding company directly or indirectly owns all businesses, constructive dividends will not be an issue. Consider using hybrids to minimize Subpart F (and foreign personal holding company) issues. There is no double U.S. taxation in this structure, but gain on sale of the foreign stock may be ordinary income under Section 1248.
C. Conduct business through a U.S. corporation: A Six Layer Cake?
1. The Top Layer: The choice of a U.S. Corporation is usually driven by non-tax factors, such as attracting investors, going public or obtaining financing. Perhaps the business already exists in this form. Consider making an S election if shareholders are individuals or qualifying trusts and the other requirements are met.
2. Layer 2: A U.S. Corporation. Companies doing business throughout the United States often choose to have their foreign companies owned by a separate U.S. corporation for state income tax reasons.
3. Layer 3: A foreign corporation in a low tax jurisdiction. Assuming we must have a U.S. "C" corporation, there should be at least one foreign corporation (not a partnership or nothing). This avoids the constructive dividend issue and provides a vehicle for managing the foreign tax credit. This also permits sale of assets or subsidiaries without U.S. taxation. Select a low tax jurisdiction to maximize opportunities for tax deferral. The jurisdiction need not be a tax haven, but could be a high tax jurisdiction that does not tax off-shore income. Such countries usually have more favorable treaty networks. Note that losses will not flow through. If losses are significant, consider having two foreign holding entities: a corporation for profitable ventures and a flow through entity to hold loss generating ventures. However consider how the loss ventures will receive new infusions of capital (i.e. the constructive dividend problem) and consider what the strategy will be when a loss venture turns profitable (the outbound transaction problem.).
4. Layer 4: Foreign entities in a low tax jurisdiction. If there will be operations in multiple countries, consider having each operation held through a separate entity in a low tax jurisdiction. This permits sale of the country X business free of scrutiny, regulation or tax by country X (depending on country X's laws.) Consider using hybrids at this and lower levels to reduce Subpart F exposure. Recall however, that hybrids may not be necessary for businesses conducted in a single low tax jurisdiction or one in which large foreign taxes cannot be avoided.
5. Layers 5 and 6: Foreign Entities in country of operation. One layer may be required by local legal or business considerations. The second layer permits intra-country dividends, distributions and sales without attracting local country withholding or other second tier taxes. Profits of the operating company can be removed from the risks of that company and segments of the business can be sold "in country" without a cross border transaction.
