By Anthony Diosdi
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(b)); 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).
Prior to the enactment of the 2017 Tax Cuts and Jobs Act, Section 958(b) provided a taxpayer friendly rule, in Section 958(b)(4), which disallowed so-called downward attribution. Specifically, Section 958(b)(4) provided the Subparagraphs (A0, (B), (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 the beneficiary’s interest in the trust is a remote contingent interest; (Section 318(a)(3)(B) states that “a contingent interest of a beneficiary in a trust shall be considered remote if, under the maximum exercise of discretion by the trustee in favor of such beneficiary, the value of such interest, computed actuarially, is 5 percent or less of the value of the trust property.”); 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 that 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, directly or indirectly, by or for such person.
For example, let’s assume that foreign person or “FP” owned all of the stock in each of a domestic corporation (“Domestic Sub”) and a foreign corporation (Foreign Sub”). Section 318(a)(3)(C) would cause FP to attribute its shares of Foreign Sub to Domestic Sub. As a result, Foreign Sub would become a CFC of Domestic Sub. Section 958(b)(4) would prevent this result.
The Congressional Conference Report to Section 958(b)(4) stated that it was repealed to “render ineffective certain transactions that are used as a means of avoiding the subpart F provisions.” Further, the Conference Report provided that one such transaction involved effectuating “de-control” of a foreign subsidiary, by taking advantage of the Section 958(b)(4) rule. Congress made this repeal retroactive to January 1, 2017. This resulted in some taxpayers being subject to the Section 965 transition tax, because the taxpayer’s foreign corporation was considered a SFC for one year.
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.
IRS Notice 2018-03 and IRS Notice 2018-26
Since the enactment of the 2017 Tax Cuts and Jobs Act, there has been a number of developments with respect to the repeal of Section 958(b)(4). In January 2018, the IRS issued Notice 2018-13, which provided temporary relief with respect to sourcing rules for space and ocean activities and international communications income such that taxpayers could determine CFC status for purposes of such rules without regard to the repeal of Section 958(b)(4). Notice 2018-03 also provided that the IRS would amend the Form 5471 instructions to provide an exception from Category 5 filing status for a U.S. person that is treated as a U.S. shareholder with respect to a CFC solely by virtue of the downward attribution rules, and no U.S. shareholder, including such U.S. person owns stock directly or indirectly in such CFC. In April 2018, the IRS issued Notice 2018-26, which provided limited relief to downward attribution for certain partnership arrangements with respect to determining SFC status for purposes of applying the Section 965 transition tax rules.
Revenue Procedure 2019-40
In certain circumstances, as a result of the repeal of Section 958(b)(4), a U.S. shareholder with respect to a foreign corporation may not be able to determine that the foreign corporation is a CFC without knowledge regarding the investments of unrelated persons. In such a case, the Treasury Department and the IRS recognize that it may not be possible to determine whether the foreign corporation is a CFC.
The Treasury Department and the IRS are aware that, in certain circumstances, taxpayers are required to include in gross income amounts under Section 951 (subpart F inclusion amounts) and 951A (GILTI inclusion amounts) attributable to, and report amounts with respect to, foreign corporations that are CFCs solely because of the repeal of Section 958(b)(4) even though those taxpayers may have limited ability to determine whether such foreign corporations are CFCs and to obtain the information necessary to accurately determine these amounts.”
Rev. Proc. 2019-40 identifies two fact patterns where a taxpayer may have difficulties completing Form 5471 as a result of the repeal of Section 958(b)(4) and the creation of the downward attribution. These are Categories 1b/1c and 5b/5c.
Simultaneously with the release of the Proposed Regulations, Treasury issued 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 had 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. 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.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign 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.