Tax Consideration Involved in the Domesticating of a CFC

The Internal Revenue Code provides that a United States shareholder of a Controlled Foreign Corporation or (“CFC”) is subject to tax on the CFC’s Subpart F or “global intangible low-taxed income” or (“GILTI”). Section 957(a) defines a CFC as a foreign corporation of which more than 50 percent of value or total combined voting power of all classes of stock entitled to vote is owned, directly, indirectly or constructively under the Section 958 ownership rules, by “U.S. shareholders” on any day during the foreign corporation’s tax year. A U.S. shareholder is a U.S. person who owns, or is considered as owning at least 10 percent of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation. In determining whether a person is a U.S. shareholder and whether the foreign corporation is a CFC, the Internal Revenue Code looks at direct ownership, indirect ownership, and constructive ownership.

The Subpart F and GILTI are anti-deferral tax regimes. Subpart F and GILTI results in most income earned by foreign corporations being subject to current U.S. taxation. All U.S. shareholders other than U.S. C corporations are disadvantaged under the Subpart F and GILTI regimes, because foreign tax credits and certain deductions (i.e., Section 250 permits a deduction of 50 percent of the GILTI amount calculated under Section 951A) apply only to domestic corporations. Unless an affected U.S. shareholder undertakes planning to minimize their tax exposure on Subpart F income and GILTI, such as the reshoring or domestication of a CFC, they will be required to include the full amount of their Subpart F or GILTI as gross income subject to the progressive federal tax rates.

To demonstrate how the domestication of a CFC can potentially take place, let’s assume that F was incorporated in Country Y. (Country Y is a hypothetical foreign country). Let’s also assume that for valid business reasons, all of the shareholders of F decided that it would be advantageous for F to become a State A corporation (State A is a hypothetical U.S. state). Under State A corporate law, a foreign corporation may become a State A corporation by filing a certificate of domestication and a certification of incorporation with the appropriate official. Pursuant to a plan of reorganization, F filed a certificate of domestication and a certificate of incorporation in State A.

Upon filing the certificate of domestication and certificate of incorporation, F was considered by State A to be incorporated in State A and became subject to State law, whether or not F continued to be considered a Country Y corporation for Country Y purposes. Thus F was not required to incorporate anew in State A, but merely “converted” itself into a State A corporation by filing the appropriate documents. For State A law purposes, the existence of F was deemed to have commenced on the date F commenced its existence in Country Y. Following the domestication, F possessed the same assets and liabilities as before the domestication and continued its previous business without interruption.

For federal income tax purposes, the conversion of F from Country Y to State A corporation under the State A domestication statute could be treated as: (1) a transfer by a foreign corporation (F) of all of its assets and liabilities to a new domestic corporation in exchange for stock; and 2) a liquidating distribution by F to its shareholders of the stock received in exchange for F’s assets and liabilities. This type of transaction could potentially qualify as a Type F tax-free reorganization under Section 368(a)(1)(F) of the Internal Revenue Code. A Type F reorganization involves “a mere change in identity, form, or place of organization of one corporation, however effected.” A transaction does not qualify as a reorganization under Section 368(a)(1)(F) unless there is no change in existing shareholders or in the assets of the corporation. However, a transaction will not fail to qualify as a reorganization under Section 368(a)(1)(F) if dissenters owning fewer than 1 percent of the outstanding shares of the corporation fail to participate in the transaction. See Rev. Rul. 66-284, 1966-2 C.B. 115.

In the example discussed above which involved the conversion of F from Country Y to State A, there was no change in the shareholders of F or in the shareholders’ proprietary interests. Furthermore, F possessed the same assets and liabilities and continued the same business activities after the conversion as F did before the conversion. Because there was no alteration in shareholder continuity, asset continuity, or business enterprise, the effect of the conversion was a mere change in the place of organization of F. Therefore, the conversion may qualify as a tax-free reorganization under Section 368(a)(1)(F) of the Internal Revenue Code, which provides that the term “reorganization” includes a mere change in identity, form or place of organization of one corporation, however effected. See Rev. Rul. 87-27, 1987-15 I.R.B. 5, concluding that the reincorporation in a foreign country of a dual resident U.S. corporation was a reorganization under Section 368(a)(1)(F).

Anytime U.S. shareholders are involved in a cross-border tax-free reorganization, Section 367 of the Internal Revenue Code must be considered. Section 367 was originally aimed at preventing tax-free transfers by U.S. taxpayers of appreciated property to foreign corporations that could then sell the property free of U.S. tax. Section 367 has two basic purposes. First, it stands sentinel to ensure that a U.S. tax liability is imposed when property with untaxed appreciation is transferred beyond U.S. taxing jurisdiction. It generally accomplishes this objective by treating the foreign transferee corporation as not qualifying as a “corporation” for purposes of certain tax-free exchange provisions of the internal Revenue Code. The domestication of a foreign corporation does not involve the transfer of untaxed appreciation beyond U.S. taxing jurisdiction. Thus, this first element of Section 367 will not be triggered.

The second purpose of Section 367 ensures that the earnings of a CFC (to the extent they are not currently taxed to U.S. shareholders) do not avoid U.S. tax because they are shifted to an entity that is not a CFC as a result of some corporate reorganization or other transaction. In this latter respect, Section 367 is the mechanism that ensures the enforcement of the rules of Section 1248, which require dividend treatment when a U.S. shareholder sells or exchanges stock in a CFC or the corporation is liquidated. The principal purpose of Section 1248 is to prevent a U.S. shareholder of a CFC from realizing gain on its undistributed earnings at the cost only of tax on long-term capital gains by selling its stock or liquidating the corporation.

Since the reshoring of a CFC would involve the use of a corporate reorganization for U.S. tax purposes, Section 1248 must be considered. Even though Section 1248 must be considered in any cross-border reorganization, it is fundamentally worth noting that Section 1248 importance has diminished because the Section 965 “transition tax” eliminated must untaxed offshore earnings and profits. Moreover, that GILTI (Global Low-Taxed Income) now causes most offshore income that is not Subpart F income to be taxed currently, with the result that there should generally not be significant untaxed earnings and profits to which Section 1248 could attach. Thus, in many cases, Section 367 and/or Section 1248 should not be an impediment to the domestication of a CFC. With that said, Section 367 and Section 1248 could trigger a tax liability if a CFC left large pools of PTEP (previously taxed earnings and profits) that will need to be repatriated as a result of a Section 954 election. In addition, the 10% QBAI amount identified under Section 951A(b)(2)(A) that is carved out from GILTI could be subject to recapture under Section 1248.

The untaxed earnings and profits of a domesticated CFC from a Section 954 election or 10% QBAI will be treated as dividend income to the extent of the relevant earnings and profits of the CFC. This dividend should trigger an exemption from tax pursuant to Section 245A dividends received deduction. However, for individual shareholders of a CFC, the situation is different. With respect to individual U.S. shareholders who domestic their CFC, the dividend triggered by Section 1248 will be taxed at ordinary rates.

The U.S. Tax Benefit Associated with Domesticating a CFC

The benefit of domesticating a CFC is that the shareholders of the corporation will no longer be subject to the Subpart F and GILTI tax regimes. In certain cases, the CFC that has been reshored can claim a Foreign Derived Intangible Income (“FDII”) deduction to significantly reduce its income liability on foreign source income. FDII was enacted as part of the 2017 Tax Cuts and Jobs Act. Under this tax regime, a C corporation may claim a deduction of up to 37.5 percent on a portion of the corporation’s FDII income. Because the current U.S. federal corporate income tax rate is 21 percent, a FDII deduction can result in an effective tax rate of only 13.125 percent (21% – 37.5% = 13.125%). If the reshored corporation is treated as a C corporation for U.S. tax purposes, in certain cases, the domesticated corporation can claim a FDII deduction.

A FDII deduction can be extremely beneficial to U.S. exporters of goods, services, and intellectual property such as the sale of software or apps, and the streaming of audio or video. A FDII deduction is not available for income received from financial services, any domestic oil and gas extraction, activities performed through a branch, and certain passive income.

The determination of the FDII deduction is a mechanical calculation that rewards a corporation that has minimal investment in tangible assets such as machinery and buildings. Specifically, FDII was designed to provide a tax benefit to income that is deemed to be generated from the exploitation of intangibles. The mechanical computation assumes that investments in tangible assets should generate a return on investment no greater than 10 percent. Thus, a corporation’s income that is eligible for the FDII deduction is reduced by an amount that equals 10 percent of the corporation’s average tax basis in its tangible assets, an amount that is known as Qualified business asset investment or “QBAI.”

The FDII deduction is determined based on the following multi-step calculation.

The FDII calculation starts with the computing of a U.S. corporation’s deduction eligible income (“DEI”). DEI is a corporation’s gross income which is adjusted to take into consideration certain items and is reduced by certain deductions allocable to gross income. DEI adjusts gross income to exclude certain types of income such as Subpart F income, dividends received from foreign controlled corporations, income from foreign branches, and GILTI.

The next step in calculating FDII is to determine a U.S. corporation’s FDDEI. FDDEI is DEI that is 1) derived in connection with property sold (including property leased, licensed, or exchanged) by a U.S. corporation to a foreign person for foreign use or 2) services provided to any foreign person. FDDEI can be broken down into the following categories: sales of general property, intangibles, and services. This includes any income derived from the sale of property to any foreign person for a foreign use. The term “sale” is specifically defined for this purpose to include any lease, license, exchange, or disposition which is not within the United States. The sale of the property must only be for foreign use. The FDII regulations provide an additional rule for the sale of general property that includes digital content. The term digital contest is defined in the regulations as a computer program or any other content in digital form. The regulations go on to provide that a sale of general property that primarily contains digital content that is transferred electronically rather than in a physical medium is for a foreign use.

Qualifying foreign income also includes income derived in connection with services provided to any person not located within the United States, or with respect to property that is not located in the United States. The services may be performed within or outside the United States (but not in a foreign branch of the domestic corporation), which limits the extent of permissible qualifying activity outside the United States. The gross foreign sales and services income is reduced by expenses properly allocated to such income. The sum of these two amounts yields foreign-derived deductible eligible income.

The general rule is that a U.S. corporation’s sales or services provided to foreign related parties are not for foreign use and, therefore, are not treated as FDDEI for purposes of the FDII deduction. Under the FDII rules, parties are generally considered to be related if they are members of an affiliated group of companies connected by more than 50 percent ownership. In certain cases, sales and services to related parties may qualify for the FDII deduction if the transaction satisfies certain additional requirements. Where a sale of property is made to a foreign related party, the outcome depends on whether: 1) the property is resold to an unrelated party or parties; or 2) the property is used in the process of providing property or services to unrelated parties. In the second case, the FDII benefit may be claimed if the seller in the related party sale reasonably expects that more than 80 percent of the revenue earned from the use of the property received in the related party transaction will be derived from unrelated party sales or services transactions that meet the substantive FDII requirements.

A related party services transaction may qualify for the FDII deduction if the services rendered are not considered to be “substantially similar” to the services provided by the related party services recipient to the person or persons located in the U.S. Under the FDII rules, the services provided by the related party service recipient are considered to be substantially similar services if: 1) 60 percent or more of the benefits conferred by the related party service ultimately accrue to persons located in the U.S.; or 2) 60 percent or more of the price paid by the persons located in the U.S. is attributable to the related party services.

Finally, a domestic corporation’s deemed intangible income is determined. The excess (if any) of the corporation’s deduction eligible income over 10 percent of its qualified business asset investment (“QBAI”). A domestic corporation’s QBAI is the average of its adjusted bases (using a quarterly measuring convention) in depreciable tangible property used in the corporation’s trade or business to generate the deduction eligible income. The adjusted bases are determined using straight line depreciation. A domestic corporation’s QBAI does not include land, intangible property or any assets that do not produce the deductible eligible income.

The FDII calculation is expressed by the following formula:

FDII = Deemed Intangible Income x  Foreign-Derived Deduction Eligible Income

     Deduction Eligible Income

The FDII computation is apparently a single calculation performed on a consolidated group A basis. Domestic corporation’s FDII is 37.5 percent deductible in determining its taxable income (subject to a taxable income limitation), which yields a 13.125 percent effective tax rate.

Foreign Tax Considerations

Anytime a reorganization of a cross-border reorganization takes place, it is important to determine if a foreign tax liability is triggered. Take for example the contribution of a CFC to a domestic holding corporation. Many foreign jurisdictions impose transfer taxes on a direct transfer of the shares of shares in a company to a U.S. corporation. Whether the reshoring of a foreign corporation can be viewed differently depends on the CFC’s jurisdiction. In some cases, the domestication of a CFC through a Type F reorganization will result in a corporation that has a residence. The domesticated corporation will be treated as  a U.S. resident at the same time the corporation could remain a resident of a foreign country. This is all possible because some countries use criteria other than place of incorporation to determine whether a corporation is a domestic resident for their tax purposes. For example, countries, such as the United Kingdom and Australia, treat corporations as a domestic resident if it is managed or controlled there, regardless of where the corporation is incorporated. Because of the application of differing criteria for determining corporate residence in certain cases, it may be possible for a reshored corporation to be treated as a dual resident corporation. On the U.S. side, this would mean that the domesticated corporation would no longer be considered a CFC and its U.S. shareholders would no longer be subject to the anti-deferral provisions of GILTI and Subpart F regimes. On the foreign side, depending on the CFC’s jurisdiction, the reshoring of the foreign corporation may potentially not be treated as a transfer of the shares of the company for transfer tax purposes. As in the case involving cross-border tax planning, foreign counsel should always be consulted to determine if the planning discussed in this article is possible and if such planning will impose a transfer tax.

Conclusion

The foregoing discussion is intended to provide a basic understanding of the basic U.S. and foreign tax considerations involved with the domestication of a CFC. It should be evident from this article that this is a relatively complex subject. It is important to note this area is constantly subject to new developments and change. As a result, it is crucial that CFC shareholders review all his or her tax planning options available with a qualified international tax attorney when planning for GILTI and Subpart F inclusions, both to ensure that the planning option is appropriate for the CFC shareholder’s specific factual circumstances, and to ensure that there has not been new developments or changes which would render that proposed planning inadvisable.

Anthony Diosdi is an international tax attorney 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.