Foreign corporations, controlled groups, and the gross receipts test

Editor: Alexander Semerano, CPA

Should foreign corporations’ gross receipts be included in determining whether a controlled group of corporations satisfies the Sec. 448(c) gross receipts test? The question is important because a controlled group may be eligible for certain tax benefits such as simplified accounting methods and access to certain credits. Accordingly, it is important to know whether to include a foreign corporation’s gross receipts as part of a controlled group.

The nuances of the Sec. 1563 controlled group rules and foreign corporations have long created confusion for taxpayers as well as clarifications from the IRS. The confusion is amplified as new laws reference the gross receipts test. Major tax law changes in 2017 increased reliance on the gross receipts test and, in turn, the controlled group rules, making these sections a focal point for tax practitioners (see also Lawson, Polizzano, and Stuardi, “Aggregation Rules Affecting Foreign-Owned Companies,” 54-10 The Tax Adviser 7 (October 2023) ).

Background

Sec. 448 was created to limit the cash method of accounting to certain businesses. In the process of creating these limitations, Congress created the gross receipts test. This test differentiated between a small business eligible to be on the cash method of accounting and a large business required to use the accrual method of accounting.

Since the enactment of Sec. 448(c) and the gross receipts test, more benefits were granted to small businesses; two examples are the exemption from the Sec. 163(j) interest limitation rules and exemption from the Sec. 263A uniform capitalization (UNICAP) rules. The gross receipts test became an important part of other laws as those laws referenced Sec. 448 to measure the size of a business. In 2017, the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, changed the definition of a small business and the gross receipts test, expanding the threshold from $5 million to $25 million in average annual gross receipts (inflationadjusted for future years). The expansion of the gross receipts test threshold increased the number of international businesses that qualified as small business taxpayers. As a result, more questions arose about which entities, units, or components of a group of companies were considered when applying the gross receipts test.

The gross receipts test received further attention when the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, created the employee retention credit (ERC), which quickly became a major cash benefit to many business taxpayers. The ERC’s mechanics may require the calculation of a taxpayer’s total gross receipts, referencing Sec. 448(c) for the definition of “gross receipts” (to measure a qualifying significant decline in gross receipts in 2020 and/or 2021). The ERC’s popularity and widespread usage should not be understated; it created a groundswell of interest in the mechanics of the gross receipts test.

Controlled groups and the gross receipts test

To determine whether the Sec. 448(c) gross receipts test is met, Sec. 448(c)(2) provides aggregation rules that must be applied. Generally, the aggregation rules combine the gross receipts of multiple taxpayers if those taxpayers are treated as a single employer under the controlled group rules of Sec. 52 or under the affiliated service group rules of Sec. 414. Both Secs. 52 and 414 reference Sec. 1563 for the definition of a controlled group of corporations. In other words, these Code sections work in concert to provide which entities should be aggregated into a controlled group to be treated as a single entity when calculating their gross receipts. These rules are intended to prevent taxpayers from artificially separating related entities so that each entity individually could receive the benefits of meeting the gross receipts test when it is clear the entities’ gross receipts should be combined.

Sec. 1563 was initially promulgated in 1964 for significantly different uses. Secs. 1563 and 1561 were created in tandem to limit the accumulated earnings credit by component members of a controlled group. Sec. 1563 later took on a more significant role as it was referenced by other sections — specifically, with the expanded definition of a small business under Sec. 448.

Sec. 1563 provides definitions and special rules relating to a controlled group of corporations and component members of those controlled groups. Sec. 1563(a) specifically describes a controlled group of corporations and the members that should be included in a controlled group. Sec. 1563(a) provides three categories of controlled groups.

First is a parent-subsidiary controlled group, which is one or more corporations connected through the stock ownership of a common parent. The common parent owns at least 80% of the shares of at least one of the other corporations.

Second is a brother-sister controlled group, in which two or more corporations meet the following two qualifications: five or fewer individuals (including trusts or estates) own more than 80% of the stock of each corporation, and the same five or fewer individuals, taking into account ownership only to the extent that it is identical with respect to each corporation, own more than 50% of the stock of each corporation.

Third is a combined group, which refers to when three or more corporations are each part of a parent-subsidiary controlled group or a brother-sister controlled group, and one of those corporations is both a parent corporation and in a brother-sister controlled group.

All three types of controlled groups use a vote or value stock ownership definition.

Sec. 1563(a) and the definition of controlled groups and their members should be contrasted with Sec. 1563(b). Sec. 1563(b)(1) defines the term “component member.” A component member is a corporation that is a member of a controlled group, including an “additional member” defined in 1563(b)(3), that is not an excluded member under Sec. 1563(b)(2). Component members are a subset of members. Sec. 1563(b) (2) lists five members that are excluded members and therefore are not component members. One excluded member, described in Sec. 1563(b)(2)(C), is a foreign corporation subject to tax under Sec. 881. Sec. 881 describes how foreign corporations that are not connected to a U. S. trade or business are taxed. In other words, foreign corporations described in Sec. 1563(b)(2)(C) are foreign corporations that are not effectively connected to a U.S. trade or business — and are therefore corporations excluded from the definition of component member.

Both Secs. 1563(a) and 1563(b) were enacted to define terms for Sec. 1561, limiting accumulated earnings credits. When these sections were codified, it was not contemplated that these terms would define members of a controlled group for other Code sections. This history is important because it helps explain why Sec. 1563 appears to be written in unclear terms. It also provides an explanation for the ambiguity in its interpretation when applied to Sec. 448.

Foreign corporations and controlled groups

Given the history and evolving uses of Secs. 1563 and 448, the confusion as to whether foreign corporations should be included in a controlled group is not a surprise. According to the IRS, taxpayers have argued that excluded members, by definition, cannot be members of a controlled group under a plain reading of Sec. 1563. We should expect taxpayers to interpret Sec. 1563 in this way because when read in the context of the gross receipts test, Sec. 1563 does not clearly create separate definitions of the terms “member” and “component member.” A cursory reading of the statute suggests Sec. 1563(b) modifies Sec. 1563(a) and excludes Sec. 881 foreign corporations as members of a controlled group. It is not a surprise that taxpayers make this argument, because it usually creates a more favorable outcome for the taxpayer. In response to this argument, the Service issued guidance stating this interpretation is wrong — Sec. 1563(b) and Sec. 1563(a) provide separate definitions of different terms. The Service has emphatically taken the position that the definition of a “member” of a controlled group in Sec. 1563(a) is not affected by the definition of a “component member” in Sec. 1563(b).

The IRS Office of Chief Counsel (OCC) provided guidance on this question in May 2002 (Chief Counsel Advice (CCA) memorandum 200233011, released Aug. 16, 2002), stating that although certain foreign subsidiaries were not component members of a controlled group under Sec.1563(b)(2)(C), that did not prevent the foreign corporations from being members of a controlled group under Sec. 1563(a). The term “component member” for purposes of Sec. 1563(b) defines a particular type of member. The OCC concluded a domestic corporation and its majority-owned foreign subsidiaries should be treated as a single taxpayer under Sec. 1563(a) because they were members of the same controlled group regardless of whether the foreign subsidiaries were excluded members of that controlled group.

Seven years later, the Service tried to stomp out any spark of a contrary position with proposed regulations. Prop. Regs. Sec. 1.1563-1(a)(1)(ii) states, “[i]n determining whether a corporation is included in a controlled group of corporations, section 1563(b) shall not be taken into account.” The preamble to the proposed regulations (REG-135005-07) discusses the original purpose of Sec. 1563 as well as subsequent statutory and regulatory provisions that have referenced the controlled group rules. The Service acknowledged that as more laws reference Sec. 1563, more taxpayers argue a corporation that is an “excluded member” within the meaning of Sec. 1563(b)(2) is not a “member” of a Sec. 1563(a) controlled group.

Predictably, the Service disagrees with this line of reasoning and in the preamble to the proposed regulations explicitly states that excluded members under Sec. 1563(b)(2), while not “component members” of a controlled group under Sec. 1563(b) (1) , are nevertheless “members” of a controlled group under Sec. 1563(a). The Service emphasized that it is a misinterpretation to equate a corporation’s status as a member with that corporation’s status as a component member, claiming its position is clearly supported by the legislative history as well as statutory language.

As a result, the Service codified in the final regulations (T.D. 9451) that a corporation identified in Sec. 1563(b)(2) as an excluded member of a controlled group is still a member of such group for purposes of Sec. 1563(a). Regs. Sec. 1.1563-1(a)(ii) states: “In determining whether a corporation is included in a controlled group of corporations, section 1563(b) and paragraph (b) of this section shall not be taken into account.”

Takeaways

Sec. 1563(a) has long been borrowed by Sec. 448 with references to Secs. 52 and 414; however, with the advent of the ERC and other recent legislation, new scrutiny will be put on Sec. 1563. As these tax benefits grow in popularity, it is expected that more taxpayers will misapply Sec. 1563(b).

Sec. 1563(a) lays out the definition of members of a controlled group. These definitions should be interpreted without regard to excluded members under Sec. 1563(b)(2). Consequently, if a foreign corporation is a member of a controlled group under any of the three definitions of Sec. 1563(a), it should be included as a member of that controlled group for the purposes of the Sec. 448(c) gross receipts test.

Editor Notes

Alexander Semerano, CPA, is a partner with Pease Bell CPAs in Cleveland.

For additional information about these items, contact Alexander Semerano at taxclinic@cpamerica.org.

Unless otherwise noted, contributors are members of or associated with CPA America.