In determining whether a U.S. person meets the Section 951(a) definition of a U.S. shareholder and whether a foreign corporation meets the Section 957(a) definition of a controlled foreign corporation (“CFC”), Section 958 applies direct, indirect, and constructive ownership rules to determine stock ownership in the foreign corporation. Stock ownership under all three types of rules counts for purposes of determining whether a shareholder is a “U.S. shareholder” and whether a foreign corporation is a “controlled foreign corporation.”
Section 958(a)(1) provides the direct ownership rules for determining stock ownership for such purposes. Section 958(a)(2) provides indirect ownership rules to determine beneficial ownership of shares when a foreign entity is interposed between the U.S. person and the foreign corporation. Specifically, stock of a foreign corporation owned, in turn, by another foreign corporation or by a foreign partnership, trust or estate is deemed to be owned proportionately by the latter’s shareholder, partners or beneficiaries. There is no minimum threshold of ownership interest in the foreign corporation necessary to trigger the application of this indirect ownership rule involving foreign entities. Thus, if a foreign partnership with four equal partners owns four percent of the stock of a foreign corporation, each partner is treated under Section 958(a)(2) as owning one percent of the stock of the foreign corporation (i.e., one-fourth of the partner’s four-percent stock interest of the corporation). Likewise, if a U.S. person owns 10 percent of the stock of a foreign corporation that owns 25 percent of a second foreign corporation’s stock, the U.S. person is treated as owning 2.5 percent of the stock of the second foreign corporation under Section 958(a)(2).
Section 958(b) applies (with several modifications) the constructive ownership rules of Section 318(a). These constructive ownership rules of Section 318(a) require attribution of stock between certain family members and between corporations, partnerships, trusts and estates, on the one hand, and the shareholders, partners or beneficiaries, on the other. Section 318(a)(5) contains certain operating rules for determining constructive stock ownership, and those operating rules apply for purposes of Section 958(b).
The attribution rules in Section 318 fall into the following four categories.
1. Family Attribution. An individual is considered as owning stock owned by his spouse, children, grandchildren, and parents. Siblings and inlaws are not part of the “family” for this purpose, and there is no attribution from a grandparent to a grandchild. See IRC Section 318(a)(5)(B).
2. Entity to Beneficiary Attribution. Stock owned by or for a partnership or estate is considered as owned by the partners or beneficiaries in proportion to their beneficial interests. See IRC Section 318(a)(2)(A). A person ceases to be a “beneficiary” of an estate for this purpose when she receives all property to which she is entitled (e.g., a specific bequest) and the possibility that she must return the property to satisfy claims is remote. Stock owned by a trust is considered as 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. See IRC Section 318(a)(2)(C).
3. Beneficiary to Entity Attribution. Stock owned by partners or beneficiaries of an estate is considered as owned by the partnership or estate. See IRC Section 318(a)(3)(A). 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. All stock owned by a 50 percent or more shareholder of a corporation is attributed to the corporation. See IRC Section 318(a)(3)(C).
4. Option Attribution. A person holding an option to acquire stock in consideration as owning that stock. See IRC Section 318(a)(4).
Section 958(b) makes the following four modifications to the Section 318(a) constructive ownership rules:
1. In applying the family constructive ownership rules in Section 318(a)(1), Section 958(b)(1) provides that stock owned by a nonresident alien individual shareholder will not be attributed to a U.S. citizen or resident alien.
2. In applying the entity-to-owner constructive ownership rules in Section 318(a)(2), Section 958(b)(2) provides that if a partnership, estate, trust or corporation owns more than 50 percent of the combined voting power of a corporation,, it will be treated as owning all of the voting stock of the corporation.
3. Section 318(a)(2)(C) treats stock owned by a corporation as owned proportionately by its shareholders, but only if the shareholders meet a minimum threshold of stock ownership in the corporation. Section 958(b)(3) reduces the threshold from 50 percent to ten percent.
4. Section 318(a)(3)(C) requires attribution of stock owned by a partner of a partnership, a beneficiary of a trust or estate or 50-percent-or-more shareholder of a corporation to the partnership, trust, estate or corporation. However, Section 958(b)(4) provides that stock owned by a foreign person (i.e., nonresident alien individual, foreign corporation, foreign partnership or foreign trust or estate) will not be attributed to a U.S. person under Section 318(a)(3)(C).
For purposes of any one determination, in applying the direct, indirect and constructive ownership rules in Section 958(a) and (b), the same stock cannot be counted twice to the same person under different indirect ownership or attribution rules or to two different persons under the same or different indirect ownership or attribution rules.
Section 958(b)(4) used to provide that subparagraphs (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 (i) stock owned, directly or indirectly, by or for a beneficiary of certain trust shall be considered as owned by the trust, unless such beneficiary’s interest in the trust is a remote contingent interest; (ii) 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) states 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 for such person.
For example, consider the situation of a foreign (“Foreign Parent Company”) that owns 100% of the shares in another foreign company (“Foreign Subsidiary Company”). Foreign Subsidiary company owns 51% of a U.S. company (“U.S. Finance Company”), but only holds non-voting shares – with the voting shares being held by a completely unrelated and independent third party. Foreign Subsidiary Company makes loans to U.S. Finance Subsidiary. If Foreign Parent Company were to directly or indirectly own a U.S. corporation (or partnership) that was not a subsidiary of Foreign Subsidiary Company, it is possible that Foreign Subsidiary Company could be considered a CFC since Foreign Subsidiary Company’s stock would be attributed from Foreign Parent Company. See Inbound Structuring for U.S. Real Estate, Robert H. Moore and Michael D. Melrose (2020). Section 958(b)(4) previously prevented this result by preventing attribution of stock under Internal Revenue Code Section 318(a)(3) from a non-U.S. person to a U.S. person.
However, Treasury Regulation Section 1.318-1(b)(1) provides that a corporation will not automatically be considered owning stock by reason of Internal Revenue Code Section 318(a)(3)(C). Treasury Regulation Section 1.318-1(b)(1) would prevent Foreign Subsidiary Company in the facts discussed above from being treated as being owned by U.S. Finance Subsidiary and being classified as a CFC. Revenue Ruling 74-605 provides as follows: Corp X owned 100% of Corp Y and Y owned 100% of Corp Z. Y purchased all of Corp S, a wholly owned subsidiary of Corp Z, for cash. This issue in this ruling was whether there was a Section 304 redemption and whether Z was in control of Y for these purposes, applying the attribution rules of Section 318. The ruling provided as follows:
Section 1.318-1(b)(1) of the regulations (which provides that a corporation is not considered as owning its own stock by reason of Section 318(a)(3)(C) of the Internal Revenue Code) is applicable to the constructive ownership of the Y stock by Z under Section 318(a)(3)(C), since, by reason of that application of Section 318(a)(3)(C), Sections 318(a)(5)(A) and Section 318(a)(2)(C) would apply to make Z the owner of its own stock. As a result, Z cannot be considered as owning the stock of Y under Section 318(a)(3)(C).
Rev. Proc 2019-40
In many cases, the repeal of Section 958(b)(4) created an impossible problem. If a U.S. person were to acquire a 10 percent interest in a foreign corporation may unknowingly have a Subpart F or Global Intangible Low-Taxed Income (“GILTI”) tax liability as the result of a foreign joint venture partner owned a U.S. entity to which the joint venture partner’s interest in the foreign corporation were attributed. This same U.S. person could be assessed penalties for failing to timely file IRS Form 5471. Rev. Proc. 2019-40 provides for a safe harbor for certain U.S. persons who cannot or do not have adequate ability to determine the CFC status of a foreign corporation.
To qualify for the safe harbor, the U.S. person cannot have actual knowledge, statements received, and/or enough reliable publicly available information for the U.S. person to determine that the Section 957 ownership requirements are satisfied. For this purpose, the term Section 957 ownership requirement means, with respect to a foreign corporation and any given day of the taxable year of the foreign corporation, stock ownership that would cause the foreign corporation to be a CFC on such day. See Rev. Proc. 2019-40, Sec 3.08.
Rev. Rule 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, statement received, or reliable publicly information sufficient to determine that the foreign corporation is a CFC; and (2) if the U.S. person inquires of the 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. Rev. Proc 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.
Rev. Proc. 2019-40 provides relief in the context of determining a U.S. shareholder’s Subpart F or GILTI inclusion. The relief comes in the form of a safe harbor to U.S. shareholders of a CFC for which there exists no Section 958(a) U.S. shareholder which is related to the CFC within the meaning of Section 954(d)(3). In such a case, a U.S. shareholder may use alternative information in determining Subpart FR and GILTI inclusions to the extent that the true information is not readily available. For purposes of Rev. Proc. 2019-40, readily available means, as of the due date of the U.S. shareholder’s return, information of the CFC that is: (a) publicly available; (b) 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 (c) 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 jurisdiction. See The Modern Day Closely Held Foreign Corporation: Post-Tax Reform, Steven Hadilogiou (2020).
Conclusion
Under Internal Revenue Code Section 958(b), stock ownership attribution rules in Section 318 generally applied to treat (1) any U.S. person as a U.S. shareholder of a foreign corporation; (2) a person as a related person within the meaning of Section 954(d)(3); (3) the stock of a domestic corporation as owned by a U.S. shareholder of a CFC for purposes of Section 956(c)(2); or (4) a foreign corporation as a CFC. As in effect before repeal, Section 958(b)94) provided that the downward attribution rules of Section 318(a)(3)(A), Section 318(a)(3)(B), and Section 318(a)(3)(C) were not to be applied so as to consider a U.S. person as owning stock owned by a foreign person.
Because of 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 a U.S. person is a U.S. shareholder of the foreign corporation and, therefore, whether the foreign corporation is a CFC. Consequently, U.S. persons that prior to the enactment of the 2017 Tax Cuts and Act may be treated as U.S. shareholders, and foreign corporations that were not previously classified as CFCs may be treated as CFCs for U.S. tax purposes. This may result in some U.S. persons unknowingly holding stock in a CFC without knowing it. In some cases, Rev. Proc. 2019-40 may provide limited relief from filing requirements and income tax consequences associated with holding stock in a foreign corporation treated as a CFC.
Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
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