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The Difficulties of Portfolio Interest Exemption Planning After the Repeal of Section 958(b)(4)

The Difficulties of Portfolio Interest Exemption Planning After the Repeal of Section 958(b)(4)

In determining whether a U.S. person meets the Section 951(b) of a U.S. shareholder and whether a foreign corporation, 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” or (“CFC”).

Section 958(a)(1) provides the direct ownership rules for determining stock ownership 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 shareholders, 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.

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 their shareholders, partners or beneficiaries, on the other. See IRC Section 318(a)(1)-(3).

(1) In applying the family constructive ownership rules in Section 318(a)(1), 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 grandparents to grandchildren.

(2) In applying the entity-to-beneficiary constructive ownership rules in Section 318(a)(2), 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). Stock owned by a trust (with the exception of a qualified employee 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. See IRC Section 318(a)(2)(B). 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) Section 318(a)(3)(C) states that 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.” A person ceases to be a “beneficiary” of an estate for this purpose when she receives all property to which she is entitled and the possibility that she must return the property to satisfy claims is remote. See Treas. Reg. Section 1.318-3(a).

(4) A person holding an option to acquire stock is considered as owning that stock. See IRC Section 318(a)(4).

Prior to the enactment of the 2017 Tax Cuts and Jobs Act, Section 958(b)(4) provided that Section 318(a)(3)(A) through (C) would not be applied to consider a U.S. person as owning stock owned by a person that is not a U.S. person. Section 318(a)(3)(A) through (C) provides the following rules for downward attribution for partnerships, estates, trusts, and corporations:

1) Stock owned directly or indirectly by or for a partner or a beneficiary of an estate is considered owned by the partnership or estate. There is no threshold for this rule. Thus, for example, if a partner has only 1 percent interest in a partnership, that partnership is treated as owning all the stock by the partner.

2) Stock owned directly or indirectly by or for a beneficiary of a trust is generally considered owned by the trust, unless the beneficiary’s interest in the trust is a remote contingent interest. Also stock owned directly or indirectly by or for a person that is considered the owner of any portion of a trust under the grantor trust rules is considered owned by the trust.

3) If 50 percent or more in value of the stock in a corporation is owned directly or indirectly by or for any person, that corporation is considered as owning the stock by or for that person.

To illustrate this rule, assume that a foreign parent corporation (“FP”) wholly owns a U.S. subsidiary (US Sub) and a foreign subsidiary (Foreign Sub). Foreign Sub does not have any Section 958(a) U.S. shareholders, because no U.S. shareholders own a direct or indirect interest in Foreign Sub. Under Sections 958(b) and 318(a)(3)(C), because FP owns 50 percent or more of the stock in US Sub, US Sub is treated as owning the stock owned by FP, which includes 100 percent of the stock of Foreign Sub. Former Section 958(b)(4) avoided this result by preventing a U.S. person (in this case, US Sub) being attributed stock owned by a foreign person (in this case, FP).

The Section 958(b)(4) limitation on downward attribution was repeated by the 2017 Tax Cuts and Jobs Act, effective for the last year of a foreign corporation before January 1, 2018. The legislative history indicates that the repeal of Section 958(b)(4) was intended to apply only in limited situations. The Conference Committee report states the intent was to “render ineffective certain transactions that are used…as a means of avoiding subpart F provisions.” However, despite statements in the legislative history indicating that Congress intended to limit the scope of Section 958(b)(4) repeal, Section 958(b)(4) was stricken from the Internal Revenue Code. The lack of a limitation on downward attribution from foreign to U.S. persons can have far-reaching effects.

One common situation in which “new” CFCs arise involves subsidiary corporations being deemed to own interests in brother-sister entities through application of the downward attribution in Section 318(a)(3). Thus, U.S. subsidiaries may be treated as owning other foreign entities in the structure, greatly increasing the number of foreign corporations treated as CFCs.

The damage from the repeal of Section 958(b)(4) extends to other contexts. One of them is the portfolio interest exemption. The portfolio interest exemption can be a very useful U.S. planning tool where an investor does not qualify for the benefits of a tax treaty that eliminates U.S. withholding tax and where foreign source interest is not subject to income tax in an individual’s or or a company’s home jurisdiction because interest paid on portfolio debt is completely exempt from U.S. withholding tax (and is thus not subject to any income taxation if not taxed outside of the United States).

The portfolio debt exemption does not apply to payment of interest to CFCs that are considered related persons with respect to the borrower. Portfolio interest generally includes interest paid on a debt obligation that is in registered form, but it excludes interest received by a CFC from a related person (defined as 1) a related person within the meaning of Section 267(b); and 2) any U.S. shareholder of the CFC, and any person that is a Section 267(b) related person to that U.S. shareholder). See Repeal of the Limitation on Downward Attribution: Three Years Later, Taxnotes (Feb. 8, 2021) by Amanda Pedvin Varma and Lauren Azebu. The repeal of Section 958(b)(4) has eliminated a number of portfolio interest planning structures.

For example, assume that a foreign individual wholly owns a foreign holding company (FSub1) that owns various investments, including a small portfolio investment in a domestic partnership (US JV). The foreign individual also wholly owns another foreign entity (FSub2), which lends money to US JV. Before the repeal of Section 958(b)(4), FSub2 would not be a CFC, and interest paid by US JV on the loan from FSub2 would be eligible for the portfolio interest exemption assuming the applicable rules governing portfolio interest were satisfied. However, after the repeal of Section 958(b)(4), U.S. JV is considered to own stock owned by its partners. Under Section 318(a)(3), FSub1 is deemed to own 100 percent of the stock of FSub2. Thus, US JV is considered to own 100 percent of the stock owned by its partner FSub 1, including the stock of FSub2, making FSub2, a CFC and US JV a U.S. shareholder.

In another example, consider the situation of a foreign company (“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 Subsidiary”), 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 that are intended to qualify for the portfolio interest exemption. If Foreign Parent Company were to directly or indirectly own a U.S. corporation or U.S. partnership that was not a subsidiary of Foreign Subsidiary Corporation’s stock would be attributed from Foreign Parent Company down to the U.S. corporation directly or indirectly owned by Foreign Parent Company. Section 958(b)(4) previously prevented this result by preventing attribution of stock under Section 318(a)(3) from a non-U.S. person to a U.S. person.

In addition, under the plain language of Internal Revenue Code Sections 318(a)(2)(C), 318(a)(3)(C), 318(a)(5)(A), Foreign Subsidiary Company could technically be a CFC without any other U.S. ownership or entity in the structure since Foreign Parent Company is deemed to own all of the shares of the U.S. Finance Subsidiary per Internal Revenue Code Section 318(a)(2)(C), which is deeded to be actually owned by Foreign Parent Company under Internal Revenue Code Section 318(a)(5)(A) and under Section 318(a)(3)(C) since the Foreign Parent Company owns more than 50% of the value of U.S. Subsidiary, U.S. Finance Subsidiary would be deemed to own all the stock in Foreign Subsidiary Company that is owned by Foreign Parent Company. See Inbound Structuring for U.S. Real Estate Latest And Greatest Structures and More (2020), by Robert H. Moore and Michael D. Melrose.

Notwithstanding the plain language of these statutes, Treasury Regulation Section 1.318-1(b)(1) provides that a corporation is not to be considered as owning its own stock by reasons of Internal Revenue Code Section 318(a)(3)(C), which would be the case if Foreign Subsidiary Company would be deemed to be a CFC by reason of ownership by a U.S. entity that is entirely owned by Foreign Subsidiary Company. Consequently, based on the facts discussed above, Treasury Regulation Section 1.318-1(b)(1) prevents Foreign Subsidiary Company from being treated as owned by U.S. Finance Subsidiary and as a CFC.


This article discusses one of the unintended consequences of the repeal of Internal Revenue Code Section 958(b)(4). If you are considering a financial structure to avoid U.S. withholding taxes on interest income, you should consult with a qualified international tax attorney to determine the implications of the repeal of Section 958(b)(4) to the proposed financial structure.

Anthony Diosdi is one of several tax attorneys and international tax attorneys 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.