Editor: Annette B. Smith, CPA
Foreign Income & Taxpayers
Sec. 952(a)(2) defines subpart F income to include foreign base company income, which includes foreign personal holding company income (FPHCI) under Sec. 954(a)(1). Under Sec. 954(c)(1)(A), FPHCI generally includes dividends, interest, royalties, rents, and annuities, unless an exception applies. Under one exception—the controlled foreign corporation (CFC) lookthrough rule of Sec. 954(c)(6)—dividends, interest, rents, or royalties received from a CFC that is a related person with respect to the recipient CFC are not treated as FPHCI to the extent attributable or properly allocable to income of the payer CFC that is neither subpart F income nor income effectively connected with a trade or business in the United States. The CFC lookthrough rule applies to CFC tax years beginning after December 31, 2005, and before January 1, 2012.
Partnership Applicability
While the CFC lookthrough rule applies to payments received by a CFC from a related CFC, how does the rule apply to payments made by a partnership to its more-than-50% partner that is a CFC? The IRS has not directly answered that question in formal or informal guidance, although it issued guidance on the application of the CFC lookthrough rule to partnerships in general in Notice 2007-9.
Section 4 of Notice 2007-9 contains parallel provisions for interest income and rent or royalty income:
- If interest is received or accrued from a partnership with one or more partners that are CFCs, such interest will be treated as received or accrued from a CFC for purposes of the CFC lookthrough rule of Sec. 954(c)(6) to the extent that such CFC partner would be treated as the payer of the rents or royalties under Regs. Sec. 1.954-2(b)(4)(i)(B).
- If rents or royalties are received or accrued from a partnership with one or more partners that are CFCs, such rents or royalties will be treated as received or accrued from a CFC for purposes of the CFC lookthrough rule of Sec. 954(c)(6) to the extent that the CFC partner would be treated as the payer of the rents or royalties under Regs. Sec. 1.954-2(b)(5)(i)(B).
Under the cited regulations, if a partnership pays interest and rents or royalties, its CFC partner will be treated as the payer of the payment to the extent that the item of deduction is allocable to the corporate partner under Sec. 704(b) if the payment gives rise to a partnership item of deduction. Therefore, if the partnership’s deduction arising as a result of the related-party payment is reasonably allocated to its CFC partner in its entirety under Sec. 704(b), the CFC partner should reasonably be treated as the payer of the interest and the rents or royalties under the regulations.
Under its literal terms, Sec. 954(c)(6) applies to interest, rents, and royalties received or accrued from a CFC that is a related person to the recipient CFC. Therefore, if the CFC partner (i.e., the party that is deemed to pay the rents or royalties for the reasons set forth above) is related to itself (i.e., the party that actually receives the related-party payments), under Notice 2007-9 the CFC lookthrough rule of Sec. 954(c)(6) should apply to such payments. Can one person be viewed as related to itself for purposes of the CFC lookthrough rule?
Partnership Payment to CFC
Although there is no authority directly on point, it may be reasonable to apply the CFC lookthrough rule to interest, rents, and royalties paid by a partnership to its more-than-50% CFC partner.
First, based on a plain reading of the language, Notice 2007-9 arguably may be interpreted to deem the partnership payer to be a CFC for purposes of applying the CFC lookthrough rule. Under this approach, assuming that the CFC partner (by itself or together with other related parties) owns 50% or more of the partnership, the partnership should be treated as a related person to the CFC partner, and the CFC lookthrough rule could then be applied to the interest and the rents or royalties paid by the partnership (a deemed CFC) to its CFC partner.
Alternatively, it could be argued, even if Notice 2007-9 were interpreted to deem the interest and the rents or royalties as paid by the CFC partner, that the CFC lookthrough rule of Sec. 954(c)(6) reasonably could be applied to the interest and the rents or royalties paid by the partnership to the CFC partner because the CFC partner should be treated as a related person with respect to itself for purposes of the CFC lookthrough rule.
Technically, the CFC partner is arguably a related person with respect to itself. Sec. 954(d)(3) provides that a person is a related person with respect to a CFC if that person is a corporation that is controlled by the same person that controls the CFC (control being defined as the direct or indirect ownership of more than 50% of the vote or value). Based on a plain reading of that definition, the CFC partner could be treated as a related person with respect to itself because it is controlled by the U.S. shareholder, the same person that controls the CFC recipient of the interest and the rent or royalty payments. To the contrary, it may be argued under Rev. Rul. 74-605 that a corporation may not be a related person with respect to itself. The holding of Rev. Rul. 74-605, however, is that a corporation is not considered as owning its own stock by reason of the Sec. 318(a)(3)(C) attribution rule, and the issue of how to define a related person for purposes of the CFC lookthrough rule is not addressed.
Such a possible interpretation also seems consistent with the legislative intent of the CFC lookthrough rule. In adopting that rule, the House Ways and Means Committee said:
Most countries allow their companies to redeploy active foreign earnings with no additional tax burden. The Committee believes that this provision will make U.S. companies and U.S. workers more competitive with respect to such countries. By allowing U.S. companies to reinvest their active foreign earnings where they are most needed without incurring the immediate additional tax that companies based in many other countries never incur, the Committee believes that the provision will enable U.S. companies to make more sales overseas, and thus produce more goods in the United States. [H.R. Rep’t No. 304, 109th Cong., 1st Sess. 45 (2005)]
To achieve such a goal, the CFC lookthrough rule essentially treats related CFCs as one entity, disregarding payments (including dividends, interest, rents, or royalties) between the related CFCs that are passive in nature, and looking to the nature of income the CFCs have earned as a whole from transactions with unrelated parties. If the latter income is non–subpart F income, the CFCs do not have subpart F income as a whole. If the CFC is deemed to have paid itself interest, rents, or royalties (passive income), it may not make sense to find such interest, rents, or royalties (which would have been essentially disregarded if paid between related CFCs) to generate subpart F income for the CFC itself to the extent that the underlying income earned by the payer from unrelated-party transactions is non–subpart F income. Such a conclusion would appear inconsistent with the legislative intent that motivated enactment of Sec. 954(c)(6).
It may be argued that the statute is clear in providing that the CFC lookthrough rule applies only to payments made from one CFC to another CFC, and therefore the CFC lookthrough rule should not apply to payments received from a partnership by its CFC partner. Such an argument, however, seems inconsistent with Notice 2007-9, which deems qualified interest, rents, or royalties to be received from a CFC for purposes of applying the CFC lookthrough rule.
In addition, while there has been no authority holding that the CFC lookthrough rule does not apply to payments received from a partnership by its CFC partner, some commentators have suggested that Regs. Secs. 1.954-2(b)(4)(i)(B) and 1.954-2(b)(5)(i)(B) apply where a partnership pays interest, rents, or royalties to a CFC partner. For example, according to McKee, Nelson, and Whitmire, Federal Taxation Partnerships and Partners ¶9.01 (WG&L 2007):
The foreign personal holding company exceptions for which the entity approach is applied do not include the § 954(c)(3) same-country exceptions. Thus, if the partnership receives a dividend, interest, rent, or royalty from a CFC, these same-country exceptions are applied by treating the CFC partner as if it received such payment directly, and by testing the same-country and related-party requirements by reference to the CFC partner. Additionally, if the partnership makes an interest, rent, or royalty payment to its CFC partner, then the rules of Reg. §§ 1.954-2(b)(4)(i)(B) and 1.954-2(b)(5)(i)(B) presumably will still apply.
The language of Regs. Secs. 1.954-2(b)(4)(i)(B) and 1.954-2(b)(5)(i)(B) seems analogous to the partnership provisions set forth in Notice 2007-9. Therefore, the quoted commentary is consistent with the approach regarding application of the CFC lookthrough rule to payments made by a partnership to its more-than-50% CFC partner.
EditorNotes
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.
For additional information about these items, contact Ms. Smith at (202) 414-1048 or annette.smith@us.pwc.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.
