By Anthony Diosdi
The Internal Revenue Code provides that a United States shareholder of a Controlled Foreign Corporation or (“CFC”) is subject to tax on the CFC’s Subpart F or “global intangible low-taxed income” or (“GILTI”). The Subpart F and GILTI are anti-deferral tax regimes. Subpart F and GILTI results in most income earned by foreign corporations being subject to current U.S. taxation. All U.S. shareholders other than U.S. C corporations are disadvantaged under the Subpart F and GILTI regimes, because foreign tax credits and certain deductions (i.e., Section 250 permits a deduction of 50 percent of the GILTI amount calculated under Section 951A) apply only to domestic corporations. Unless an affected U.S. shareholder undertakes planning to minimize their tax exposure on Subpart F income and GILTI, such as the reshoring or domestication of a CFC, they will be required to include the full amount of their Subpart F or GILTI as gross income subject to the progressive federal tax rates.
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. Thus, this first element of Section 367 will not be triggered.
The second purpose of Section 367 ensures that the earnings of a CFC (to the extent they are not currently taxed to U.S. shareholders) do not avoid U.S. tax because they are shifted to an entity that is not a CFC as a result of some corporate reorganization or other transaction. In this latter respect, Section 367 is the mechanism that ensures the enforcement of the rules of Section 1248, which require dividend treatment when a U.S. shareholder sells or exchanges stock in a CFC or the corporation is liquidated. 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.
Since the reshoring of a CFC would involve the use of a corporate reorganization for U.S. tax purposes, Section 1248 must be considered. Even though Section 1248 must be considered in any cross-border reorganization, it is fundamentally worth noting that Section 1248 importance has diminished because the Section 965 “transition tax” eliminated must untaxed offshore earnings and profits. Moreover, that GILTI (Global Low-Taxed Income) now causes most offshore income that is not Subpart F income to be taxed currently, with the result that there should generally not be significant untaxed earnings and profits to which Section 1248 could attach. The untaxed earnings and profits of a foreign corporation could be subject to Section 1248 in reorganization should be limited to the 10 percent qualified business asset investment or QBAI (e.g., Section 959(c)(3) E&P attributable to QBAI) amount identified under Section 951A(b)(2)(A) that is carved out from GILTI or foreign source income that is subject to high rates of foreign tax and an election was made under Section 954 to exclude such income from GILTI or Subpart F income. Although the amount of earnings and profits that could attach to a Section 1248 recapture in most cases could potentially be insignificant, the Section 1248 “taint” should be considered in any reorganization involving the domestication of a CFC.
The 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 GILTI tax regimes. Subpart F and GILTI 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 GILTI 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 13.125% under the foreign-derived intangible income or (“FDII”) provisions of the Internal Revenue Code. FDII is a type of income that when earned by a U.S. domestic C corporation is entitled to a deduction equal to 37.5 percent. Because the current U.S. federal corporate income tax rate is 21 percent, FDII income is taxed at an effective rate of 13.125 percent. The determination of FDII is a mechanical calculation that rewards a corporation that has minimal investment in tangible assets. FDII was enacted by Congress to provide a tax benefit to income that is deemed to be generated from the exploitation of intangibles.
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 GILTI 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 his or her tax planning options available with a qualified international tax attorney when planning for GILTI 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 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.