Does a Quirk in the Hypothetical Distribution Rule Permit Some CFC Shareholders to Avoid the Subpart F and GILTI Tax Regimes?

Where a foreign corporation is characterized are a “Controlled Foreign Corporation” (“CFC”), its “United States Shareholders” are taxed annually on the “Subpart F income” and “Global Intangible Low-Taxed Income” (“GILTI”) of the CFC, whether or not such earnings are distributed at the time, and on the CFC’s increased investment in certain U.S. property. A CFC is classified as a foreign corporation in which more than 50 percent of its stocks are owned (by vote or value), directly or indirectly by “United States shareholders.” Under U.S. tax law, a U.S. shareholder is a U.S. person that owns directly, indirectly, or constructively, at least ten percent of the foreign corporation by voting power or by value.

As discussed above, CFCs are taxed annually on Subpart F income and GILTI. Under Section 954 of the Internal Revenue Code, Subpart F income is defined as foreign base company income. Foreign base includes a category of income known as personal holding company income which consists of dividends, interest, royalties, rents, annuities, and net gains from certain property from the sale or exchange of the following types of property: 1) property that produces income that produces dividends, interest, royalties, rents, or annuities; 2) an interest in a trust, partnership, or real estate mortgage investment company; and 3) property that does not give rise to any income.

Subpart F income is not classified as a dividend under the Internal Revenue Code. See Notice 2004-70, 2004-2 CB 724. Therefore, Subpart F income cannot be treated as a qualified dividend and as a result, Subpart F income is taxed as ordinary income to CFC shareholders whether or not such income is distributed to its shareholders. A U.S. shareholder’s GILTI is the shareholder’s “net CFC tested income” for the tax year, less the shareholder’s “net deemed tangible income return” for the year. Net CFC tested income is generally the shareholder’s ratable share of net income or loss of all CFCs of which the individual or entity is a U.S. shareholder, less certain amounts subject to U.S. tax and net deemed tangible income return which is typically 10 percent of the shareholder’s pro rata share of the tangible depreciable property of all CFCs. In other words, GILTI typically excludes a 10 percent return on tangible assets from CFC net tested income from U.S. taxes. However, this deemed return is reduced by a net interest expense of any CFC that is “taken into account” in determining the shareholder’s net CFC tested income for the tax year.

For individual shareholders, GILTI is taxed at ordinary income tax rates. Currently, ordinary income may be taxed at a maximum rate of 37 percent.  However, individual CFC shareholders can make an election under Section 962 of the Internal Revenue Code to tax GILTI at the corporate tax rate which is 21 percent. By making a Section 962 election, an individual shareholder can further reduce the tax on GILTI to 10.5 percent.

Under Treasury Regulation Sections 1.951A-1(d)(2) and 1.951-1(e), a U.S. shareholder’s Subpart F and GILTI taxable amounts are based on a hypothetical distribution of earnings and profits (“E&P”) at the end of the CFC’s tax year. If a CFC has only one class of outstanding stock, the amount of the corporation’s allocable E&P is determined as if the hypothetical distribution was made pro-rata with respect to ownership of the CFC’s stock. In cases of multiple classes of stock, the regulations looks to the distribution rights of each class of stock on the hypothetical distribution date and utilizes an “all facts and circumstances” test that considers terms of each stock class, agreements among shareholders, “and, if to the extent appropriate fair market value of shares of stock.” See Treas. Reg. Section 1.951-1(e)(3). But, the regulations excludes “distribution[s] in liquidation” from the determination of allocable E&P for purposes of the hypothetical distribution. See Treas. Reg. Section 1.951-1(e)(4)(i). A restriction or limitation on a distribution of E&P by a CFC is typically not taken into account in determining the amount of a CFC allocable E&P under the hypothetical distribution rules. See Treas. Reg. Section 1.951-1(e)(5)(i).With that said, the right to periodically receive a fixed amount (whether determined by terms of a certain amount of U.S. dollars or foreign currency, or otherwise) with respect to a class of stock of which the distribution of which it is a condition precedent to a further distribution of the E&P that year with respect to any class of stock is not a restriction or other limitation on distribution of E&P by a CFC. See Treas. Reg. Section 1.951-1(e)(5)(iii).

The regulations provide detailed rules for calculating income inclusions from so-called lower-tier CFCs. Section 951(a) of the Internal Revenue Code requires U.S. shareholders of certain CFCs who own within the meaning of Section 958(a) stock in such corporations to include their pro-rata share of its Subpart F income. Section 951(b) of the Internal Revenue Code defines a U.S. shareholder with respect to any foreign corporation to include a U.S. person who owns, within the meaning of Section 958(a), 10% or more of the total combined voting power of all classes of stock of such foreign corporation or 10% or more of the total vote or value of shares of all classes of stock of such foreign corporation. For equity interests held by a first-tier CFC, Section 958A0(2) of the Internal Revenue Code and Treasury Regulation Section 1.958-1(b) provide that stock owned directly or indirectly by or for a foreign corporation is considered as being proportionally by its shareholders, partners, or beneficiaries, and that for purposes of reapplying this rule, such stock is treated as actually owned. Attribution under this rule stops with the first United States person in the chain of ownership running from the foreign entity.

Treasury Regulation Section 1.958-1(c)(2) states as follows: “A person’s proportionate interest in a foreign corporation, foreign partnership, foreign trust, or foreign estate will be made on the basis of all facts and circumstances in each case” and that for purposes of determining such proportionate interest, “the purpose for which the rules of Section 958(a) and this section are being applied will be taken into account.” For example, “if the rules of Section 958(a) are being applied to determine the amount of stock owned for purposes of Section 951(a), a person’s proportionate interest in a foreign corporation will generally be determined with reference to such person’s interest in the income of such corporation.” The regulation provides this general rule. But, the regulation goes on to say that “any arrangement which artificially decreases a United States person’s proportionate interest will not be recognized.” Because stock owned for purposes of Section 951 is defined as “within the meaning of Section 958(a),” Section 958(a)(1)(B) includes stock owned with the application of Section 958(a)(2), Section 958(a)(2), and Treasury Regulation 1.958-1(b) include proportionately owned while stopped such chain ownership at the first United States person. Consequently, any stock owned by a U.S. person in a lower-tier CFC is evaluated under the rules of Section 951. However, the determination of the “proportionate interest” must be done “on the basis of all the facts and circumstances” and that “the purpose for which the rules of Section 958 and this section are being applied will be taken into account. The Department of Treasury and the Internal Revenue Service (“IRS”) have promulgated very little guidance in regards to the “proportional interest” rule.

Treasury Regulation Section 1.951-1(e)(7)(iii) Example 2 provides an example for determining the amount of Subpart F income for a cFC with common stock and nonparticipating voting preferred stock outstanding stock and nonparticipating voting preferred stock outstanding by calculating the hypothetical distribution on the preferred stock (4% preferred * $10 per value share * 30 shares = $12), using that amount to determine the proportion of the first-tier entity’s pro-rata share of Subpart F income (i.e., the numerator is the balance of earnings and profits after the preferred distribution ($100 total E&P – $12 preferred stock E&P = $88) and the denominator is the total amount of earnings and profits ($100)) and then finally multiplying such pro-rata share proportion ($88/$100 = 88%) by the amount of Subpart F income ($50) to arrive at $44 of pro-rata Subpart F income. If the first-tier CFC owned all the common stock of a second-tier CFC that also had Subpart F income, it is not clear whether the “facts and circumstances” result in a 0% interest to the preferred shareholders (their preference amount does not change because they still only have a $12 preference) or whether there should be some proportionate amount so the preferred stock also take into account their lower-tier subsidiary’s total E&P and Subpart F income when conducting the same calculation discussed above.

The “New York State Bar Association Tax Section has provided additional guidance. The New York State Bar Association has stated there is a gap in the regulations for lower-tier subsidiaries in a series of examples where one shareholder owns common stock and a second shareholder owns preferred stock that accrues dividends at a rate of 20% of par value per annum. See “New York State Bar Association Tax Section Report on Proposed Regulations Regarding the Determination of a Shareholder’s ‘Pro Rata Share’ Under Section 951,” 2005 TNT 29-55. The New State Bar Tax Section suggests that the correct approach may be to have each shareholder’s interests in the lower-tier subsidiary be the same as the shareholder’s interests in the upper-tier subsidiary for purposes of calculating any Subpart F income inclusion. The New York State Bar Tax Section explains the consequences of the hypothetical distribution rule with the upper-tier CFC’s shareholders having the same interest in the E&P of the lower-tier CFC. As the New York State Bar Tax Section explains, by simply duplicating the preferred stock interest for each lower-tier subsidiary, the preferred stock could receive an allocation based on the preferred return multiple times- once when the calculation is done at the upper-tier level and again each time the calculation is done for each lower-tier CFC level. The New York State Bar Section of Taxation states that this duplication “is clearly not the right answer under the hypothetical distribution rule.” In the alternative, the New York State Bar Section of Taxation states that the preferred return should be applied with respect to the upper-tier subsidiary or be applied with respect to the lower-tier subsidiary. The New York State Bar of Taxation does not make a determination as to which method should be utilized.

As discussed above, a U.S. shareholder’s Subpart F and GILTI inclusion amounts are calculated on the basis of a hypothetical distribution of E&P at the end of the year. See Treas. Reg. Sections 1.951A-1(d)(2) and 1.951-1(e). These calculations are based on the distribution rights of each class of stock considering the terms of each stock class, agreements among the shareholders, and in some cases the relative fair market value of the shares of the stock. See Treas. Reg. Section 1.951-1-1(e)(3). As indicated above, the regulations disregard for this purpose many restrictions or limitations on distributions of E&P by a CFC, such as an arrangement that restricts the ability of a CFC to pay dividends on a class of stock of the corporation until a condition or conditions are satisfied (for example, until another class of stock is redeemed). However, the regulations state that the right to periodically receive a fixed amount with respect to a class of stock the distribution of which is a condition precedent to a further distribution of E&P that year in the context to any class of stock is not a restriction or other limitation on the distribution of E&P by a CFC. See Treas. Reg. Section 1.951-1(e)(5)(iii).

Consequently, preferred stock that pays a small coupon or fixed amount is exempted from this provision. Thus, a preferred stock paying a small coupon or fixed amount each year could potentially be treated differently from stock that pays no dividends. The foregoing rules regarding restrictions seem to be aimed at temporary restrictions on E&P distributions rather than stock that by its terms does not pay dividends. The term “restriction” generally encompasses a limitation on something such as the regulations’ examples of “an arrangement that restricts the ability of a CFC to pay dividends on a class of stock of the corporation until a condition or conditions are satisfied by redemption, a loan agreement is entered into by a CFC that restricts or otherwise affects the ability to make distributions on its stock until certain requirements are satisfied or an arrangement that conditions the ability of a CFC to pay dividends to its shareholders on the financial condition of the corporation.”

Under these rules, if a class of shares of a CFC do not carry any rights to receive, nor will they ever pay, dividends to their holders, a position can potentially be taken that U.S. shareholders that hold such stock would receive zero in hypothetical distributions under Section 951 (Subpart F income) and Section 951A (GILTI) with respect to preferential shares.

Any U.S. shareholder of a CFC should consult with a qualified international tax attorney to determine if planning is available to reduce their exposure to the Subpart F and GILTI tax regimes.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. 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.