By Anthony Diosdi
This article will attempt to explain the attribution rules for stock ownership for individuals and entities regarding the filing requirements of the Form 5471. Form 5471 is used by certain U.S. persons who are officers, directors, or shareholders in respect of certain foreign entities that are classified as corporations for U.S. tax purposes. The Form 5471 and schedules are used to satisfy the reporting requirements of Internal Revenue Code Section 6038 and 6046 along with the applicable regulations.
Substantively, Form 5471 backstops various international provisions of the Internal Revenue Code such as Sections 901/904 (Foreign Tax Credit), Section 951(a) (Subpart F and Section 956), Section 951A (GILTI), Section 965 (transition Tax), Section 163(j) (interest deduction limitation), and Section 482 (transfer pricing). International information returns that often are associated with Form 5471s include Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation), Form 5713 (International Boycott Report), Form 8621 (PFIC), Form 8990 (Limitation on Business Interest Expense), and Forms 1116/1118 (Foreign Tax Credit).
Defining Key Terms For Purposes of Understanding the Attribution Rules and Form 5471
We will begin our discussion of the attribution rules with a definition of key terms:
U.S. Person
Only U.S. persons can have a Form 5471 filing obligation. A U.S. person is generally a citizen or resident of the United States, a domestic partnership, a domestic corporation, or a domestic trust or estate as defined by Section 7701(a)(30). A tax-exempt U.S. entity may have a Form 5471 filing obligation.
U.S. Shareholder
Internal Revenue Code Section 951(b) defines a “U.S. shareholder” as a U.S. citizen, resident alien, corporation, partnership, trust or estate, owning directly, indirectly or constructively under the ownership rules of Section 958, ten percent or more of the total combined voting power of all classes of stock of a foreign corporation or the value of all the outstanding shares of a foreign corporation.
Controlled Foreign Corporation (“CFC”)
A foreign corporation is a CFC if, on any day during the foreign corporation’s taxable year, U.S. shareholders own more than 50 percent of the combined voting power of all classes of stock, or more than 50 percent of the total value, of the foreign corporation. Only U.S. shareholders are considered in applying for the 50 percent test. All forms of ownership, including direct, indirect (ownership through intervening entities), and constructive (attribution of ownership from one related party to another), are considered in applying the 50 percent test.
Section 965 Specified Foreign Corporation (“SFC”)
An SFC is a foreign corporation that is either a CFC or has at least one U.S. shareholder that is a corporation. In other words, the term SFC includes not only CFCs, but also entities commonly referred to as 10/50 companies. These foreign companies have at least one U.S. shareholder, but are not CFCs because U.S. shareholders do not own more than 50 percent of the entity by vote or value.
Form 5471 Filing Requirements
A Form 5471 and schedules must be completed and filed by certain categories of filers discussed below.
Category 1 Filer
A Category 1 filer is a U.S. shareholder of a SFC at any time during any taxable year of the SFC who owned that stock on the last day in that year on which it was an SFC. A SFC is a CFC, or any foreign corporation with one or more 10 percent domestic corporation shareholders.
Category 2 Filer
A Category 2 filer is a U.S. citizen or resident who is an officer or director of a foreign corporation in which there has been a change in substantial U.S. ownership – even if the change relates to stock owned by a U.S. person who is not an officer or director. A substantial change in U.S. ownership is when any U.S. person (not necessarily the U.S. citizen or resident who is the officer or director) acquires stock that causes him or her to own a 10 percent block, or acquires an additional 10 percent block, of stock in that corporation. More precisely, if any U.S. person acquires stock, which, when added to any stock previously owned, causes him or her to own stock meeting the 10% stock ownership requirement, the U.S. officers and directors of that foreign corporation must report. A disposition of shares in a foreign corporation by a U.S. person does not create filing obligations under Category 2 for U.S. officers and directors. Stock ownership is a vote or value test.
Category 3 Filer
A U.S. person is a Category 3 filer with respect to a foreign corporation for a year if the U.S. person does any of the following during the tax year:
1. Acquires stock in the corporation, which, when added to any stock owned on the acquisition date, meets the Category 2 filer 10 percent stock ownership requirement.
2. Acquires additional stock that meets the 10 percent stock ownership requirement.
3. Becomes a U.S. person while meeting the 10 percent stock ownership requirement.
4. Disposes of sufficient stock in the corporation to reduce his or her interest to less than 10 percent stock ownership requirement.
5. Meets the 10 percent stock ownership requirement with respect to the corporation at a time when the corporation is reorganized.
Stock ownership is a vote or value test. Section 958 applies direct, indirect, and constructive ownership rules to determine stock ownership in the foreign corporation. These ownership rules require attribution of stock between certain family members, such as brothers or sisters, spouse, ancestors, and lineal descendants and between corporations, partnerships, trusts and estates. These attribution rules fall into the following four categories.
1. Family Attribution. An individual is considered as owning stock owned by his spouse, children, grandchild, and parents. Siblings and inlaws are not part of the “family” for this purpose, and there is no attribution from grandparent to a grandchild.
2. Entity Beneficiary Attribution. Stock owned by or for a partnership or estate is considered owned by the partners or beneficiaries in proportion to their beneficial interests. A person ceases to be a “beneficiary” of an estate for this purpose when he receives all property to which he is entitled and the possibility he must return the property to satisfy claims is remote. Stock owned by a trust is considered owned by the beneficiaries in proportion to their actuarial interests in the trust. In the case of grantor trusts, stock is considered owned by the grantor or other person who is taxable on the trust income. Stock owned by a corporation is considered owned proportionately (comparing the value of the shareholder’s stock to the value of all stock) by a shareholder who owns, directly or through the attribution rules, 50 percent or more in value of that corporation’s stock.
3. Beneficiary to Entity Attribution. Stock owned by partners or beneficiaries of an estate is considered as owned by the partnership or estate. All stock owned by a trust beneficiary is attributed to the trust except where the beneficiary’s interest is “remote” and “contingent.” Grantor trusts are considered to own stock owned by the grantor or other person taxable on the income of the trust.
4. Option Attribution. A person holding an option to acquire stock is considered as owning that stock.
Category 4 Filer
A U.S. person is a Category 4 filer with respect to a foreign corporation for a taxable year if the U.S. person controls the foreign corporation. A U.S. person is considered to control a foreign corporation if at any time during the person’s taxable year, such person owns: 1) stock possessing more than 50 percent of the total combined voting power of all classes of stock entitled to vote; or 2) more than 50 percent of the total value of shares of all stock of the foreign corporation. For Category 4 purposes, U.S. persons include those individuals who make a Section 6013(g) or (h) election to be treated as resident aliens of the United States for income tax purposes.
The constructive ownership rules discussed above are applied to determine if the U.S. person “controls” the foreign corporation.
Category 5 Filer
A Person is a Category 5 filer if the person: 1) is a U.S. shareholder of a CFC at any time during the CFC’s taxable year; and 2) owns stock of the foreign corporation on the last day in the year in which that corporation is a CFC. For category 5 purposes, constructive ownership is determined under Section 318 (discussed above) as modified by Section 958(b). Pursuant to Section 958(b), there is no attribution from a nonresident alien relative.
New Categories
Categories 1 and 5 have been expanded to 1a, 1b, 1c, 5a, 5b, and 5c in order to separate those filers who are under some relief and may not need to file the same schedules.These new categories will distinguish those 5471 filers who only need to file a Form 5471 due to downward attribution caused by the repeal of Section 958(b)(4) and will therefore not be required to attach certain schedules to their Form 5471s.
Category 1a filer is one who is not defined as a Category 1b or Category 1c filer. Thus, a Category 1a filer is anyone who is greater than 50 percent owner of an SFC.
Category 1b filer is an unrelated Section 958(a) U.S. shareholder. A Category 1b filer is an unrelated person who would not control (more than 50% vote or value) the SFC or be controlled by the same person which controls the SFC.
Category 1c filer is a related constructive U.S. shareholder. A Category 1c filer is typically an entity controlled by (more than 50% vote or value) the same person which controls the SFC and files only due to this downward attribution.
Category 5a filer is one who is not defined as a Category 5b or a Category 5c filer. Thus, a Category 5a filer is anyone who is greater than 50 percent owner of CFC.
Category 5b filer is an unrelated Section 958(a) U.S. shareholder. A Category 5b filer is an unrelated person who would not control (more than 50% vote or value) the CFC or be controlled by the same person which controls the CFC.
Category 5c filer is a related constructive U.S. shareholder. A Category 5c filer is typically an entity controlled by (more than 50% vote or value) the same person which controls the CFC and files only due to this downward attribution.
Attribution Rules- the Basics
The Internal Revenue Code provides that a U.S. shareholder of a CFC is subject to tax on the CFC’s Subpart F or GILTI income. 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. This means that for classification purposes, a U.S. person is constructively treated as owning stock in a foreign corporation that is owned by certain entities or individuals that are related to that U.S. person. For example, if a U.S. tax resident mother owns 6 percent of a foreign corporation and her U.S. tax resident daughter owns another 7 percent of the same foreign corporation, they each will be considered U.S. shareholders, because they are treated as constructively owning the shares of the other.
Attribution Rules of Section 958(a) and 958(b)
To prevent avoidance of the stock ownership rules by dividing ownership among related persons, Internal Revenue Code Section 958 provides detailed ownership rules and attribution rules. Under Section 958(a), stock owned directly or indirectly by a foreign corporation, foreign partnership, foreign trust or foreign estate is considered as being owned proportionately by its shareholders, partners or beneficiaries. Stock so considered as owned is treated as actually owned for purposes of applying the direct and indirect ownership rules.
In the CFC context, Section 958(b) provides that the constructive ownership rules of Section 318(a), with certain modifications, apply for purposes of determining whether: 1) a U.S. person is a U.S. shareholder (within the meaning of Section 951(a); 2) a foreign corporation is a CFC under Section 957; 3) the stock of a domestic corporation is owned by a U.S. shareholder of a CFC for purposes of Section 956(c)(2); and 4) a corporation or other person is related to the CFC for purposes of Section 954(d)(3). Thus, for example, under Section 318(a)(2), stock owned directly or indirectly by a foreign trust is treated as considered as owned by its beneficiaries in proportion to the actuarial interests of such beneficiaries. Section 958(b) also provides special rules of application for the constructive ownership rules of Section 318, the most important of which is that in applying the family attribution rules, stock owned by a nonresident alien individual, other than a foreign trust or foreign estate, is not to be attributed to a U.S. citizen or resident alien.
Section 958(a) Compared to Section 958(b) and Repeal of Section 958(b)(4)
An important difference between the direct/indirect ownership rules of Section 958(a) and the constructive ownership rules of Section 958(b) is that the constructive ownership rules apply only for purposes of categorization, whereas the direct/indirect ownership rules will apply in determining taxation of a CFC’s income to U.S. Shareholders as well as for purposes of categorization.
Internal Revenue Code Section 958(b) provides several modifications to the Section 318 constructive ownership rules. In particular, Section 958(b)(4) provided for a rule which disallowed attribution from a foreign individual to a U.S. tax resident individual. Prior to the 2017 Tax Cuts and Jobs Act, Section 958(b)(4) disallowed so-called disallowed downward attribution. Specifically, Section 958(b)(4) provided that “[s]ubparagraphs (A), (B), and (C) of Section 318(a)(3) shall not be applied so as to consider a United States person as owning stock which is owned by a person who is not a United States person.” Section 318(a)(3)(A) provides that stock owned, directly or indirectly, by or for a partner or a beneficiary of an estate shall be considered as owned by the partnership or estate. In general, Section 318(a)(3)(B) provides that (1) stock owned, directly or indirectly, by or for a beneficiary of certain trusts shall be considered as owned by the trust, unless beneficiary’s interest in the trust is a remote contingent interest; 2) stock owned, directly or indirectly, by or for a person who is considered the owner of any portion of a trust under the grantor trust rules shall be considered as owned by the trust. Section 318(a)(3)(C) provides if 50 percent or more in value of the stock in a corporation is owned, directly or indirectly, by or for any person, such corporation shall be considered as owning the stock owned, directly or indirectly, by or such person.
Due to the repeal of Section 958(b)(4), stock of a foreign corporation owned by a foreign person can be attributed to a U.S. person under Section 318(a)(3) for purposes of determining whether such person is a U.S. shareholder of the foreign corporation and, therefore, whether the foreign corporation is a CFC. As a result of the repeal of former Section 958(b)(4), Section 958(b) now provides for “downward attribution” from a foreign person to a U.S. person in circumstances in which pre-2017 Tax Cuts and Jobs Act Section 958(b) did not otherwise provide and foreign corporations that were not previously treated as CFCs may be treated as CFCs.
The constructive attribution rules may cause a foreign corporation to be a “deferred foreign income corporation” for purposes of Section 965 based on the other assets of its shareholders and related parties. The term “deferred foreign income corporation” means, with respect to any United States shareholder, any specified foreign corporation of such United States shareholder which has accumulated post-1986 deferred foreign income. For example, an individual shareholder, whether foreign or a U.S. citizen, may own 50 percent of a domestic C corporation’s stock and 10 percent of a foreign corporation’s stock. Internal Revenue Code Section 318(a)(3)(C) treats a C corporation as constructively owning any stock owned by a 50-percent or greater shareholder, so the domestic C corporation constructively owns 10 percent of the foreign corporation’s stock. Because the foreign corporation has a constructive 10 percent corporate U.S. shareholder, it is a SFC, which causes Section 965 to apply to its individual U.S. shareholders. The result is the same if the domestic C corporation’s stock instead is 50 percent owned by the individual’s foreign grandparent. The individual shareholder’s 10 percent of the foreign corporation is constructively owned by the grandparent of Section 318(a)(1)(A), and the stock is further constructively owned by the domestic C corporation.
The repeal of Section 958(b)(4) also has an adverse effect on a number of portfolio interest planning structures. For example, consider a foreign investor who, through one entity, owns 10 percent of a partnership to invest in the U.S., and, through another entity, lends money into the U.S. If another investor in the partnership has a domestic corporation, because of the downward attribution rules the partnership is potentially deemed to own the foreign subsidiary that is making the loan in as well as potentially a domestic corporation.
Revenue Procedure 2019-40
The IRS acknowledged that U.S. persons may have phantom income inclusions under the subpart F and GILTI rules, and reporting requirements, with respect to foreign-controlled CFCs, even though the U.S. person may have limited ability to determine whether such foreign corporations are CFCs and to obtain the information necessary to accurately determine such amounts and comply with such reporting requirements. To address these issues, Revenue Procedure 2019-40 provides certain safe harbors whereby an individual may be treated as having complied with such tax obligation (and relieved of penalties) despite having incomplete information. Revenue Procedure 2019-40 attempts to alleviate challenges faced by a taxpayer in obtaining information that may not be possible for the taxpayer to obtain. Revenue Procedure 2019-40 provides a number of safe harbords with respect to determining CFC status and items of income.
In many cases, the repeal of Section 958(b)(4) created an impossible information problem. For example, if a U.S. person were to acquire a 10 percent interest in the Foreign Sub, the U.S. person unknowingly have a GILTI inclusion because the foreign joint venture partner owned a U.S. entity to which the joint venture partner’s interest in the foreign corporation was attributable. Short of demanding an audit of the Foreign Parent’s global structure, the U.S. person may have no way of knowing if the Foreign Sub is a CFC. See The Modren Day Closely Held Foreign Corporation Post-Tax Reform, Steven Hadjilogiou and Fred Murrary (2020). Even worse, if the U.S. person were to acquire stock in a foreign corporation, after which acquisition the foreign corporation is not a CFC, and later a foreign shareholder with a domestic subsidiary acquires stock in the foreign corporation, the U.S. person could, now, unknowingly hold stock in a CFC without any notice of the change in status.
Prior to the repeal of Section 958(b)(4), if a foreign corporation was a CFC, it generally meant that at least 50 percent of its items of subpart F income were taken into gross income by U.S. shareholders either directly or indirectly. As a result, there would be sufficient shareholder concern that proper accounting of the CFC books were made so that the U.S. shareholders could properly report their respective shares of subpart F income and return the proper tax. Now, with downward attribution, there are many scenarios in which only a small minority of shareholders may have any compliance or tax liability with respect to the subpart F or GILTI inclusions. Such scenarios may result in the impossibility to comply with U.S. tax laws.
To address these types of situations, Revenue Procedure 2019-40 provides certain safe harbors whereby an individual may be treated as having complied with the tax compliance obligations despite having incomplete information.
The Revenue Procedure 2019-40 states that the IRS will respect the non-CFC determination of a foreign corporation made by a U.S. person if: 1) the U.S. person does not have actual knowledge, statements received, or reliable publicly available information sufficient to determine that the foreign corporation is a CFC; and 2) if the U.S. person inquires of the foreign top-tier entity in which it holds an interest as to whether that entity is a CFC, whether that entity owns, directly or indirectly, an interest in any foreign corporation, and whether that entity owns, directly or indirectly, an interest in any domestic entity. Importantly, Revenue Procedure 2019-40 clarifies that the U.S. person is not required to inquire of the foreign shareholder whether it owns interests in U.S. domestic corporations or partnerships.
Further, Revenue Procedure 2019-40. provides relief in the context of determining a U.S. shareholder’s subpart F or GILTI inclusions with respect to a CFC is not readily available and there Section 958(a) U.S. Shareholders that is related to the CFC, an unrelated Section 958(a) U.S. Shareholders generally may determine its inclusion amounts using “alternative information.” For this purpose, “alternative information” generally means readily available separate-entity financial statements, with certain adjustments. In this sense, readily available means, as of the due date of the U.S. shareholder’s return, information of the CFC that is: 1) publicly available; 2) with respect to an interest acquired prior to October 2, 2019, available to the U.S. shareholder by using reasonable efforts and subject to a legal or contractual right to obtain by the U.S. shareholder; or 3) with respect to an interest acquired after October 1, 2019, information which the CFC is not prohibited from providing to the U.S. shareholder under the laws of the subject jurisdictions. Similarly, if information necessary to accurately calculate Section 965 transition tax amounts with respect to a SFC is not readily available, a shareholder generally may determine its transition tax amounts using “alternative information.”
It is important to understand that Revenue Procedure 2019-40 does not provide any changes to the statutory framework. Revenue Procedure 2019-40 clarifies the taxpayer’s ability to make determinations and determine income of a CFC in situations where the taxpayer does not have information, the party that has the relevant information is not related to the taxpayer and the information is otherwise unavailable to the taxpayer. In all other cases, the repeal of 958(b)(4) continues to cause challenges.
Conclusion
The attribution and constructive ownership rules are complex. A misapplication of these rules can have serious consequences. The IRS may assess a $10,000 penalty for the failure to substantially complete and accurate Form 5471 timely. An additional $10,000 continuation penalty may be assessed for each 30 day period that noncompliance continues up to $60,000 per return, per tax year. In addition, the IRS can assess a 40 percent accuracy penalty and reduce foreign tax credits by 10 percent. If you have an interest in a foreign corporation (either directly or indirectly), you should consult with a qualified international tax expert.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in cross-border tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & 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.