Can Interposing a U.S. Holding Company in a CFC Ownership Chain Reduce NCTI?

Net CFC tested income (“NCTI”) regime under Internal Revenue Code Section 951(a) captures a significant amount earned by a controlled foreign corporation (“CFC”). The U.S. federal income tax liability associated with NCTI is dramatically different to an individual CFC shareholder compared to domestic subchapter C corporation. Individual CFC shareholders are subject to NCTI tax at federal rates of up to 37 percent (plus 3.8 percent medicare tax, applicable state and local taxes). Absent planning, individual CFC shareholders cannot claim indirect foreign tax credit to reduce U.S. federal income tax liability. On the other hand, domestic C corporations are typically only subject to tax on NCTI inclusions at a federal rate between 12.6% to 14%. In addition, a domestic C corporation may utilize an indirect foreign tax credit of 90 percent of the amount of foreign taxes paid to reduce NCTI inclusions for U.S. federal tax purposes.

Because the U.S. federal liabilities are so excessive on GILTI inclusions, many individual CFC shareholders have taken an “if you can’t beat them, join them” mentality and have established domestic holding or blocker companies to hold CFC shares to reduce NCTI inclusions. Establishing a domestic holding or blocker company to hold CFC shares has a number of benefits. But with those benefits come some downsides. This article will discuss NCTI planning opportunities associated with transferring CFC shares into a holding company.

Summary of the NCTI Tax Regime

Similar to Subpart F, NCTI is an anti-deferral regime applicable to U.S. shareholders of CFCs. NCTI is a U.S. shareholder’s net CFC tested income. Tested income means the excess (if any) of a CFC’s gross tested income for a CFC inclusion year over the allowable deductions (including taxes) properly allocable to the gross tested income for the CFC inclusion year (a CFC with tested income for a CFC inclusion year is a “tested income CFC”). Tested loss means the excess (if any) of a CFC’s allowable deductions (including taxes) properly allocable to gross tested income (or that would be allocable to gross tested income if there were gross tested income) for a CFC inclusion year over the tested income of the CFC for the CFC inclusion year (a CFC without tested income for a CFC inclusion year is a “tested loss CFC”).

NCTI is beneficial for corporate U.S. shareholders (i.e., U.S. C corporations). In general, a corporate U.S. shareholder is deemed to have paid 90% of foreign income taxes by its CFCs in connection for foreign tax credit purposes. That is, a domestic corporation can make a Section 250 deduction equal to 40 percent of the NCTI inclusion. This deduction effectively reduces the current 21 percent federal corporate rate to 12.6% to 14% percent on a NCTI inclusion. Second, a domestic C corporation may elect to use a foreign tax credit equal to 90 percent of the foreign taxes paid on NCTI income.

Unfortunately, the mechanisms that were created to ensure this result are only applicable to U.S. shareholders that are domestic corporations. That is, individual shareholders of CFCs cannot claim a Section 250 40% deduction or a 90 percent credit for foreign taxes paid. As a result, individual CFC taxpayers are subject to tax on a NCTI inclusion at federal rates of up to 37 percent.

Contributing CFC Shares to a Domestic C Corporation

In order to reduce the sting of a NCTI inclusion, an individual CFC shareholder may contribute his or her shares to C corporation. This would result in the C corporation becoming a U.S. shareholder of the CFC. The short-term benefits of this strategy are clear. The contribution, when structured properly, should qualify as a tax-free Section 351 contribution. (Shareholders in an incorporation transaction will not recognize any gain or loss on the exchange if they satisfy three requirements of Internal Revenue Code Section 351(a)). First, there must be a contribution of property. Second, the contribution must be solely in exchange for stock and, third, the contributors must control the corporation immediately after the exchange).

NCTI earned by a C domestic corporation should receive the benefits of the Section 250 deduction and flow-through of foreign tax credits. In addition, a distribution of the CFC’s previously taxed earnings and profits (“PTEP”) should not be subject to further U.S. federal tax. Moreover, if the CFC has any E&P (that is not otherwise PTEP) a distribution of such an amount from the CFC to a domestic corporation may qualify for the Section 245A participation exemption. Internal Revenue Code Section 245A allows an exemption for certain foreign income of a domestic C corporation that is a U.S. shareholder by means of a 100 percent dividends received deduction for the foreign-source portion of the dividends. Proper planning may also result in dividend distributions from the C corporate holding company qualifying for reduced qualified dividend rate of 20 percent (plus medicare, state, and local taxes).

However, anyone considering transferring CFC shares into a domestic C corporate holding company must understand there are significant long term costs. First, typically, if an individual were to sell CFC shares, the gain on such sale would likely be classified as long-term capital gain for federal tax purposes. Long-term capital gains are subject to federal income tax at a preferential 20 percent rate. To the extent that the CFC has E&P, then some or all of this gain may be recharacterized as a dividend under Section 1248. Under Section 1248(a) of the Internal Revenue Code, gain recognized on a U.S. shareholder’s disposition of stock in a CFC is treated as dividends to the extent of relevant E&P accumulated while the person held the stock. With respect to individual U.S. shareholders who sell shares of a C corporation holding CFC shares, recharacterization is significant due to the rate differential between long-term capital gains, (maximum 20 percent) and ordinary income (maximum 37 percent).

In addition, on the sale of the CFC stock by a domestic C corporation, the shareholder of the domestic C corporation is subject to two layers of tax. First, the sale of CFC stock by the domestic C corporation would be subject to 21 percent federal corporate tax rate. A second layer of tax is assessed when the C corporation makes a distribution of the CFC gains to its shareholders. Planning opportunities may be used to reduce or even eliminate the 21 percent corporate rate on the sale of CFC shares. This could be done by making an election under Section 338(g) of the Internal Revenue Code. When a Section 338(g) election is made, the target CFC is deemed to sell its assets and must recognize any gain resulting from the deemed asset sale. If the seller is a domestic C corporation, the CFC target’s gain on non-trade or business assets typically is classified as Subpart F income, and the remaining gain (with respect to trade or business assets) instead is classified as tested income for NCTI purposes. The CFC’s tax year closes, and its Subpart F income and NCTI through the date of sale are included in the gross income of the domestic C corporate seller.

With a Section 338(g) election, the domestic seller also will be taxed on the gain from the sale of the CFC stock, with the basis of such stock being increased to account for any inclusions under Subpart F or NCTI for the year (including the Subpart F and GILTI income generated by the deemed asset sale). Subject to holding period requirements, the stock gain will be recharacterized as a dividend under Section 1248 and generally will be deductible under Section 245A to the extent of the CFC’s prior year untaxed earnings and profits and current year earnings that are not Subpart F income or tested income, as well as earnings arising from gain on deemed sale of assets that are not subject to Subpart F or NCTI. Because of the dividends received under Section 245A, there may be a preference for C corporate sellers toward dividend characterization under Section 1248 (i.e., a stock sale), which may be exempt from U.S. tax under Section 245A, as compared to gain that may be classified as NCTI income (i.e., an asset sale), which would trigger a 12.6% to 14% corporate tax. However, if sufficient E&P exists, corporate sellers will likely prefer stock sales over asset sales. In this case, utilizing a Section 338(g) election will convert gains to NCTI tax which will be taxed 12.6% to 14% percent.

The liquidation or distribution of the sale proceeds of CFC would be subject to an additional tax at the shareholder level. As discussed above, this may be reduced to 20 percent for federal income tax purposes. A word of caution when using C corporate structure to hold CFC shares. Some holding corporations are developed to avoid shareholder level tax by simply failing to make corporate distributions. In these cases, the Internal Revenue Service (“IRS”) may assess penalty taxes under the provisions of the accumulated earnings tax and the personal holdings company tax.

The accumulated earnings penalty tax is imposed upon corporations “availed of for the purpose of avoiding the income tax with respect to its shareholders…by permitting earnings and profits to accumulate instead of being divided or distributed.” See IRC Section 532(a). Once the IRS determines that a corporation is subject to the accumulated earnings penalty tax, a tax imposed upon “accumulated taxable income” at the 37 percent top marginal tax rate imposed on individuals. See IRC Sections 532, 535. Under the personal holding company tax provisions of the Internal Revenue Code, a penalty tax is imposed upon undistributed personal holding companies at the top individual marginal tax rate of 37 percent. See IRC Section 541.

Contributing CFC Shares to a Partnership or S Corporation

CFC shareholders may also contribute CFC shares to flow-through structures such as partnerships or S corporations through tax-free transactions. Compared to utilizing a C corporate corporation, placing  CFC shares through flow-through structure does not result in a second layer of tax. Individuals that place CFC shares into flow-through structures may also be able to foreign tax credits without a 90 percent limitation. However, flow-through structures are not likely eligible to utilize the Section 250 deduction. Thus, a flow-through structure may not be an optimal structure if the CFC is operating in a zero or low tax country. There still remains some uncertainty regarding S corporations holding CFC shares with accumulated E&P and PTEPs. As a result, the IRS intends to issue regulations addressing these issues in the near future.

Conclusion

There is no one size fits all solution when it comes to NCTI planning. Careful modeling should be done by a qualified international tax attorney prior to proceeding with a GILTI tax reduction plan.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning. Anthony is a frequent author and speaker on international tax topics.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.