The Rise of Type F Reorganizations: Key Tax Considerations for Domestication of Foreign Corporations

Certain publicly traded foreign corporations have recently considered the possibility of “migrating” to the U.S. for various economic, strategic, and other commercial reasons. In addition, non-U.S. corporations are considering going public and are increasingly considering reincorporating to the U.S. in advance of an IPO. Foreign corporate migration to the U.S. is a stark change to the 2000 through 2017 period when corporate inversions were a trend. Redomesticating or reincorporation of a foreign corporation to the U.S. commonly arises in the cross-border mergers and acquisition context. It can also arise in a stand-alone situation. This article will examine the domestication of a Controlled Foreign Corporation (“CFC”) in a stand-alone situation through a Type F reorganization.

Why Domesticate a Foreign Corporation?

In the past, many U.S. corporations have inverted to avoid high domestic taxation. Recent changes in the tax law has made inversions less attractive. There are also a number of non-tax reasons for U.S. corporations to remain in the U.S. and for foreign corporations to domesticate. The most common reason to domesticate a corporation is the asset to the capital markets. Major U.S. stock market indices e.g. S&P, Russell, and CRSP are generally intended to be composed of U.S. companies publicly traded in the U.S. markets. To be eligible for index inclusion, each index provider requires the applicable corporation to satisfy various fixed criteria, including being domiciled in the U.S., as determined for index purposes. Key conditions for inclusion typically include common stocks, subject to SEC reporting as a domestic issuer, primarily listed on a major U.S. exchange (NYSE, Nasdaq or other qualified exchange). It is very difficult for a foreign corporation to be classified as a U.S. company for purposes of index eligibility.

Mechanics of a Domestication of a CFC

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. Although a domestication of a foreign corporation does not involve the transfer of untaxed appreciated assets outside the U.S., inbound “F” reorganizations are subject to special rules of Section 367(b) and Treasury Regulation Section 1.367(b)-3 that override the normal tax-free reorganization rules. Generally, these rules require U.S. shareholders to include their share of the domesticating foreign corporation’s “all earnings and profits amounts” (“E&P”) as taxable income. The purpose of Section 367(d) is to ensure that U.S. tax is imposed on the repatriation of previously-untaxed earnings of a foreign corporation. In the days of the anti-deferral professions such as GILTI in a post 2017 Tax-Cuts and Jobs Act, few U.S. shareholders of CFCs have untaxed E&P. However, a careful examination of the CFC and U.S. shareholders should be done prior to the contemplated domestication to avoid any unpleasant tax surprises. In certain cases, shareholders of a CFC may have untaxed E&P as a result of making a 962 election.

In addition, as indicated above Treasury Regulation Section 1.367(b)-3 may apply to a domestication of a CFC. Treasury Regulation Section 1.367(b)-3 requires a U.S. shareholder within the meaning of Section 951(b) (a “U.S. Shareholder”) to include in income as a deemed dividend all E&P amount with respect to its stock in the foreign corporation. All E&P amount generally means the net positive E&P of the foreign corporation attributable to such stock under Section 1248 principles [E&P attributable to holder’s holding period), but without regard to rules not relevant to determining pro rata portion of E&P (status of corporation as CFC, status of holder as 10% holder) and excludes lower-tier E&P. 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.

It is worth noting that Section 1248 is of diminished relevance because of the Section 965 “transition tax” eliminated most untaxed offshore E&P, leaving large pools of PTEP (previously taxed earnings and profits) that will be repatriated without further tax, as well as triggering corresponding basis increases in CFC stock in most cases. However, Section 1248 may still apply to a domesticating CFC as a result of the 10% QBAI amount identified under Section 951A(b)(2)(A) that was carved out from GILTI or untaxed E&P as a result of claiming a high-tax exemption under Section 954.

Can Section 245A?

If there is inclusion of E&P from a CFC in connection with its domestication, the inclusion of the E&P may qualify as a Section 245A “deemed deduction.” This section allows a domestic corporation a deduction for certain dividends received from a foreign corporation. For this reason, conversion of gain into dividend income may be good for a CFC domesticating to the U.S., assuming the CFC meets the requirements of Section 245A (e.g., the shareholder must be a domestic corporation, the U.S. corporation must own at least 10% of the vote or value of the foreign corporation, the corporation must hold the foreign stock more than 365 days during the 391-day window around ex-date date). Certain earnings are not eligible for the Section 245A “deemed deduction.” These earnings include the following:

1. Extraordinary Deduction Accounts as defined in Treasury Regulation Section 1.245A-5(c).
2. Hybrid Deduction Accounts as defined in Treasury Regulation Section 1.245A(e)-1.

Often Overlooked 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 NCTI (Net CFC Tested Income) tax regimes. Subpart F and NCTI only applies to U.S. shareholders of a CFC. Once the CFC is reshored, it will no longer be classified as a CFC for U.S. tax purposes and as a result, the U.S. shareholders of the corporation will no longer be subject to Subpart F or NCTI inclusions. In addition, if a domesticated corporation sells or leases tangible or intangible property to non-U.S. customers, the corporation may be subject to a U.S. federal tax rate of only 14% under FDII. The FDII deduction was enacted as part of the 2017 Tax Cuts and Jobs Act. Similar to the changes from NCTI to NCTI, the OBBBA renamed what used to be “foreign derived intangible income” to “foreign derived deduction eligible income” (“FDDEI”). FDDEI permits a 33.34% deduction. This results in a 14% effective tax rate on FDDEI.

A FDDEI 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 FDDEI 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 FDDEI 14% federal tax rate is not only available to domestic exporters of goods and services, with proper planning, even U.S.-exporters of goods and services can take advantage of FDDEI favorable rates.

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 NCTI 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 planning options available with a qualified international tax attorney when planning for NCTI 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 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.