As the world continues to get smaller, forward-looking companies are finding that doing business overseas is not just a luxury but a necessity to keep pace with increased competition. Many small and midsize businesses now find themselves owning foreign subsidiary corporations, meaning they are managing the same international tax issues once reserved for large publicly held companies.
Small and midsize businesses are often organized as S corporations, partnerships (including limited liability companies treated as partnerships for tax purposes), and even as sole proprietorships. While these forms of business offer certain domestic tax benefits (namely, the avoidance of double taxation inherent in C corporations), international tax provisions, including the anti-deferral regime and mechanics of the foreign tax credit, can present significant and unique challenges to maintaining a tax-efficient structure.
Under Sec. 951(a), U.S. taxpayers must include in income their share of subpart F income and their share of Sec. 956(a) income. Subpart F of the Code was originally enacted to address concerns that taxpayers could defer certain types of U.S. income tax by placing the income in a foreign corporation organized in a low-tax jurisdiction, consequently deferring the U.S. tax until it was repatriated. Subpart F is primarily directed at two types of income: passive investment income and income derived from dealings with related corporations. Both of these types of income may be easily movable from one taxing jurisdiction to another.
Although the nuances of subpart F are extremely complex (and beyond the scope of this item), the basic operation is fairly simple: certain U.S. taxpayers are denied deferral treatment and instead are taxed directly on certain income earned by controlled foreign corporations (CFCs). CFCs are defined as foreign corporations in which U.S. shareholders own more than 50% of either the stock's combined voting power or its value (Sec. 957(a)). A "United States shareholder" is a U.S. person owning at least 10% of the voting power of the corporate stock (Sec. 951(b)).
In addition to a ratable share of subpart F income, a U.S. shareholder must include in gross income its pro rata share of any increase in the CFC's investment of earnings in U.S. property. Generally, earnings brought back to the United States in this manner are taxed to the shareholders because this is substantially equivalent to a paid dividend (Secs. 951(a) and 956(a)).
In general, U.S. property includes (1) tangible property located in the United States, (2) stock of a domestic corporation, (3) an obligation of a U.S. person, or (4) any other right to use in the United States a copyright, patent, invention, model, design, formula, process, or similar property right the CFC acquired or developed for use in the United States (Sec. 956(c)(1)). A CFC's pledge or guarantee of an obligation of a U.S. person is considered an acquisition of the underlying obligation by the CFC. Therefore, the CFC is considered to have itself invested in U.S. property.
The term "obligation of a United States person" includes all instances of debt, with some exceptions such as indebtedness arising out of an involuntary conversion of non-U.S. property and obligations arising out of the CFC's providing services to the U.S. person to the extent the amount does not exceed what would be ordinary and necessary to carry on the business of the CFC or the U.S. person if they were unrelated. Obligations payable within 60 days are considered as meeting the ordinary and necessary test (Temp. Regs. Sec. 1.956-2T(d)(2)).
For C corporations, the Sec. 951(a) income inclusion provisions merely thwart the ability to enjoy U.S. tax deferral on profits earned within a foreign subsidiary. While this result is not ideal, noncorporate taxpayers could endure an even worse fate—double taxation on this phantom income.
Availability of Indirect Tax Credits
The foreign tax credit regime exists to prevent U.S. taxpayers from paying U.S. income tax on income that has already been taxed by a foreign jurisdiction. Under Sec. 901(b), U.S. citizens and domestic corporations may credit income taxes paid to foreign countries (subject to the limitations of Sec. 904(a)). Generally, a taxpayer may only claim a credit for foreign income tax paid by itself. However, Sec. 960 allows domestic corporations with Sec. 951(a) income to claim a credit for taxes the underlying foreign corporation paid, as if the U.S. taxpayer paid these taxes directly. This deemed-paid credit is claimed by U.S. shareholders in the same year the undistributed income is taxed to them. This provision permits matching of foreign tax credits with the related Sec. 951(a) income. To qualify for these indirect tax credits, the domestic corporation must meet certain requirements, including owning at least 10% of the foreign corporation's voting stock (Sec. 902(a)).
Sec. 960 specifically applies only to "domestic corporations." Therefore, it is not available to individuals, partnerships or their partners/members, or S corporations or their shareholders, even if all of the requirements are otherwise satisfied. This means that those taxpayers are subject to current U.S. tax on their share of Sec. 951(a) income but cannot claim a foreign tax credit for the foreign taxes paid by the CFC, resulting in double-taxed phantom income.
Noncorporate taxpayers can often sidestep the potentially bad results of the anti-deferral regime by taking advantage of certain subpart F exceptions (namely, the manufacturing exception, the same-country exception, or the de minimis exception)—all of which are beyond the scope of this item.
Taxpayers may also be able to use the check-the-box rules of Regs. Sec. 301.7701-3 to avoid the inclusion under Sec. 951(a). Since their inception, check-the-box regulations have provided taxpayers with various planning opportunities. The regulations permit "eligible entities" to choose among various business classifications. An eligible entity may classify itself as a corporation, partnership, or single-member entity—one that will be ignored for U.S. tax purposes. Since Sec. 951(a) income can occur only when a U.S. taxpayer owns an entity classified as a CFC, the check-the-box rules allow taxpayers to effectively remove themselves from these rules by electing that the entity originally classified as a CFC be treated as either a foreign disregarded entity (wholly owned) or a foreign partnership—two ownership forms not covered by Sec. 951.
Not much help: Despite all of these opportunities, some taxpayers still find themselves subject to the anti-deferral provisions. This can occur for a variety of reasons:
- The business operational model may not allow for any of the subpart F exceptions to be met;
- To provide financing, lenders may require U.S. taxpayers to pledge the stock of the foreign subsidiary, causing a potential Sec. 956(a) inclusion;
- The foreign entity may be organized as an entity not eligible to make a check-the-box election; or
- Taxpayers or their advisers fail to recognize the existence of Sec. 951(a) income until after year end.
Luckily, taxpayers ineligible for the Sec. 960 indirect tax credit have yet another option available to help mitigate the harmful effects of Sec. 951(a) income inclusions.
Sec. 962 Election
Sec. 962 allows an individual U.S. shareholder to claim an indirect tax credit under Sec. 960 by electing to be taxed at corporate income tax rates on Sec. 951(a) income only. By making this election, the shareholder may claim an indirect foreign tax credit for foreign taxes the CFC paid.
Sec. 962, which was originally enacted with the other subpart F provisions, was designed to allow individuals investing in foreign corporations to elect the same treatment they would have had if they had invested through a domestic corporation doing business abroad. By permitting individual investors to claim indirect foreign tax credits, it attempts to lessen the income tax consequences for U.S. taxpayers seeking foreign investment, so that decisions can be based on business factors and not tax reasons.
Who may elect: An election under Sec. 962 may be made only by a U.S. shareholder who is an "individual" (including a trust or an estate) (Regs. Sec. 1.962-2(a)). Partnerships and S corporations may not make a Sec. 962 election, although partners or S corporation shareholders who are considered U.S. shareholders should be able to make a Sec. 962 election (Rev. Rul. 69-124). For this reason, partnerships and S corporations that have Sec. 951(a) income should consider separately stating and disclosing this information on Schedules K-1, thereby allowing the partners and shareholders to evaluate whether making this election is in their best interest.
Time and manner of making election: To make this election, an individual U.S. shareholder must file a statement with his or her return for the tax year in which he or she wishes to make the election, indicating his or her intent to make an election, and providing certain information as prescribed in the regulations (Regs. Sec. 1.962-2(b)).
Effect of election: A Sec. 962 election is valid and binding only for the shareholder who makes the election and only for the tax year for which the election is made. The election is made separately for each year and need not be made consistently from year to year (Regs. Sec. 1.962-2(c)(1)). If the individual is a U.S. shareholder of more than one CFC, the election applies to the Sec. 951(a) income from all of them.
Thus, a taxpayer can chose whether to make the election on a year-by-year basis, depending on which alternative is better. For example, in years in which the CFC generates a Sec. 951(a) income inclusion, a shareholder may find it advantageous to make the Sec. 962 election. However, in years where there is no Sec. 951(a) inclusion, it may be better to not make the election and take advantage of the income deferral.
Mechanics: An electing shareholder's tax on Sec. 951(a) income is determined as though these amounts had been received by a domestic corporation and the hypothetical corporate recipient had no other income. In the same way, the indirect credit for the electing shareholder is determined as though the Sec. 951(a) inclusions had been received by a domestic corporation.
Treatment of actual distributions: Normally, Sec. 959(a) provides that actual distributions of previously taxed Sec. 951(a) income are excluded from income. However, Sec. 962(d) provides that Sec. 962 earnings and profits (Sec. 962 E&P)—amounts previously included in income under Sec. 951(a) under a Sec. 962 election—are not eligible for the Sec. 959(a) exclusion. Distributed amounts in excess of the tax previously imposed under Sec. 962 are considered income. For this reason, taxpayers could potentially subject themselves to a higher effective tax rate by making a Sec. 962 election, even though they could still garner deferral benefits if the CFC delayed its distribution of profits.
Qualified dividends: Whether Sec. 962 E&P distributions are considered qualified dividends under Sec. 1(h)(11)(C) is an interesting question and remains an unresolved issue. Sec. 1(h)(11)(B) defines "qualified dividend income" as dividends received during the tax year from domestic corporations and qualified foreign corporations. "Qualified foreign corporations" include any foreign corporation that is eligible for the benefits of an income tax treaty with the United States, which includes an exchange-of-information program (Sec. 1(h)(1)(C)(ii)).
Sec. 962 provides that the Sec. 962 E&P distribution is included in gross income, similar to Sec. 951(a) inclusions. It does not specifically indicate that it is treated as a dividend.
In Notice 2004-70, the IRS clearly indicated that Sec. 951(a) inclusions are not considered dividends and therefore are not eligible for preferential tax treatment. The IRS could therefore argue that actual distributions of Sec. 962 earnings are not eligible for the qualified dividend rates. However, this position would seem to be inconsistent with the legislative history of Sec. 962, which was enacted to provide certain taxpayers with "assurance that their tax burdens, with respect to these undistributed foreign earnings, will be no heavier than they would have been had they invested in an American corporation doing business abroad" (S. Rep't No. 1881, 87th Cong., 2d Sess. 92 (1962)). This suggests that distributions of Sec. 962 E&P should indeed be taxed at qualified dividend rates.
Treating distributions of Sec. 962 E&P as qualified dividends mitigates the effects of Sec. 962(d)'s trumping of Sec. 959(a). This approach would mean that the Sec. 962 election has the effect of converting a portion of the Sec. 951(a) inclusions, taxed at marginal rates up to 39.6%, into qualified dividend income, which is currently taxed at much more favorable rates.
Taxpayers who find themselves facing Sec. 951(a) income inclusions without the ability to claim an indirect tax credit could find relief through Sec. 962. By broadening the applicability of Sec. 960's indirect tax credit, Sec. 962 could provide the best alternative (and maybe a last resort) for certain shareholders facing the potentially harsh consequences of the anti-deferral regime.
Anthony Bakale is with Cohen & Company Ltd. in Cleveland. For additional information about these items, contact Mr. Bakale at 216-774-1147 or firstname.lastname@example.org. Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.