Aggregation rules affecting foreign-owned companies

Editor: Mark Heroux, J.D.

Multinational businesses headquartered overseas customarily conduct operations in the United States via local subsidiaries. These U.S. companies, often structured as domestic corporate taxpayers, support their global organizations’ efforts in reaching the American market and tapping local pools of talent, technology, and resources. It is not uncommon, at least in the initial phases of market penetration, for the size of the U.S. subsidiaries’ activities to be small compared to the revenues and assets of the global group. This type of scenario raises questions as to whether the U.S. subsidiary, because of its moderate size, can qualify for certain beneficial federal tax rules generally targeting small businesses or, instead, should be excluded from the scope of such benign provisions on account of the aggregation rules requiring that the local operations be viewed as part of their larger group.

In the past few years, similar concerns have come to the forefront in connection with legislation enacted in response to the financial disruption caused by the COVID-19 pandemic. Practitioners and businesses have faced significant uncertainty when it came to determining whether foreign-owned U.S. businesses could apply qualification testing by excluding their affiliates’ overseas operations to take full advantage of programs and provisions such as the Paycheck Protection Program or the employee retention credit.

Even beyond these temporary provisions, the relevance of aggregation rules expands to important areas such as qualification for simplified tax accounting methods, exemption from the interest limitation rules under Sec. 163(j), and exemption from the uniform capitalization (UNICAP) rules under Sec. 263A. This item discusses how these rules apply in the context of U.S. corporations that are controlled by larger international groups.

Small business gross-receipts exemption under Sec. 448(c)

Small businesses are exempted from the applicability of several unfavorable Internal Revenue Code sections if their gross receipts do not exceed a certain threshold under Sec. 448(c). More specifically, businesses meet the exemption if they have no more than $25 million in average annual gross receipts for the three prior tax years, unless they are deemed to be a tax shelter. The gross-receipts threshold is indexed for inflation and is set at $29 million for tax years beginning in 2023 (an increase from $27 million for tax years beginning in 2022 and $26 million for tax years beginning in 2021, 2020, and 2019).

Several critical Code sections rely on the Sec. 448(c) test, including but not limited to:

• Cash-basis method of accounting: In general, Sec. 448(a) prohibits a C corporation, a partnership that has a C corporation as a partner, or a tax shelter from using the cash method of accounting. If the C corporation or partnership with a C corporation as a partner meets the gross-receipts test under Sec. 448(c) and is not a tax shelter, this prohibition does not apply.
• Exemption from the business interest deduction limitation: In general, Sec. 163(j)(1) limits the deduction of trade or business interest expense to business interest income plus 30% of adjusted taxable income (plus any “floor plan financing” interest). Under Sec. 163(j)(3), a taxpayer that meets the gross-receipts test under Sec. 448(c) and is not a tax shelter is not subject to the limitation under Sec. 163(j) on deducting business interest expense.
• Exception from UNICAP rules under Sec. 263A: In general, Sec. 263A requires a taxpayer to capitalize certain direct and indirect costs as a part of the cost of tangible property it produces and property it acquires for resale. Under Sec. 263A(i), a taxpayer that meets the gross-receipts test under Sec. 448(c) and is not a tax shelter is not subject to these UNICAP rules. (For a discussion of how this small business exception can be used in the real estate context, see “A UNICAP Exception for Real Estate Development” on page 23.)
• Completed-contract accounting method: In general, Sec. 460 requires taxpayers to use the percentage-of-completion method for long-term contracts, which recognizes income as production occurs. Under Sec. 460(e)(1)(B), a taxpayer that meets the gross-receipts test under Sec. 448(c) and is not a tax shelter may account for long-term contracts by the completed-contract accounting method for any contracts estimated to be completed within two years. The completed-contract method allows the taxpayer to defer revenue that would otherwise be recognized throughout production.

Aggregation rules capturing foreign affiliates

Simply applying the gross-receipts rules identified above to determine whether a taxpayer was exempt from the application of Secs. 163(j), 263A, etc. might inadvertently overlook the aggregation rules that may require the gross receipts of other entities, such as foreign affiliates, to be included in the analysis.

Taxpayers who are treated as a single employer under Sec. 52(a) or (b) or Sec. 414(m) or (o) are considered a single taxpayer for Sec. 448(c) purposes (Sec. 448(c)(2)). Accordingly, the gross receipts of all aggregated entities in these instances must be included when applying the gross-receipts test.

The discussion now turns to the rules under Secs. 52(a) and (b) in the context of foreign affiliates’ activity that must be considered for purposes of the tests identified above.

Controlled group of corporations under Sec. 52(a): Sec. 52(a) refers to Sec. 1563(a) to define a controlled group of corporations, with modifications (most significantly, by reducing the ownership threshold for establishing a parent-subsidiary controlled group to “more than 50%,” down from “at least 80%”).

Notably, there might appear to be a means to exclude certain foreign affiliates under Sec. 1563(b)(2)(C), which provides that a foreign corporation subject to tax under Sec. 881 (imposed on certain income of foreign corporations without income that is effectively connected with the conduct of a trade or business within the United States) is excluded from being a component member of a controlled group of organizations. For reference, whether a corporation is considered a component member of a controlled group has a bearing on whether it is apportioned various tax benefits of the group, tax bracket sharing (prior to the flat 21% rate imposed by the law known as the Tax Cuts and Jobs Act, P.L. 115-97), etc.

However, Regs. Sec. 1.1563-1(a) (1)(ii) states that Sec. 1563(b) is not taken into account for purposes of determining whether a corporation is part of a controlled group. As such, even if the entity is excluded from being a component member, it is still included in the controlled group. Consider Example (3) from Regs. Sec. 1.1563-1(b)(4) (emphasis added):

Throughout 1964, corporation M owns all the stock of corporation F which, in turn, owns all the stock of corporations L1, L2, X, and Y. M is a domestic mutual insurance company subject to taxation under section 821, F is a foreign corporation not engaged in a trade or business within the United States, L1 and L2 are domestic life insurance companies subject to taxation under section 802, and X and Y are domestic corporations subject to tax under section 11 of the Code. Each corporation uses the calendar year as its taxable year. On December 31, 1964, M, F, L1, L2, X, and Y are members of a parent-subsidiary controlled group of corporations. However, under paragraph (b)(2) (ii) of this section, M, F, L1, and L2 are treated as excluded members of the group on December 31, 1964. Thus, on December 31, 1964, the component members of the parent-subsidiary controlled group of which M is the common parent include only X and Y.

The AICPA recommended to the IRS in a Dec. 21, 2020, letter that “for purposes of applying the gross receipts test under section 448, taxpayers should take into account the component member rules of section 1563(b), such that gross receipts of foreign corporations subject to tax under section 881 would be excluded from the aggregation rules which would reduce controversy and provide additional administrative simplicity.” To be clear, the AICPA acknowledged that a foreign corporation “does not appear to be excluded from a controlled group of corporations for purposes of applying the gross receipts test.”

Controlled group of organizations under Sec. 52(b): Sec. 52(b) and the regulations thereunder make no mention of foreign organizations. However, Sec. 52(b) states: “The regulations prescribed under this subsection shall be based on principles similar to the principles which apply in the case of subsection (a).” Based on this language, as well as the absence of any express exclusion of foreign organizations from a controlled group, it appears that foreign organizations would need to be included if the requisite ownership tests are met.

Small corporations may be unaware of aggregation rules

As succinctly put by the AICPA in its Dec. 21, 2020, letter: “Many small United States (U.S.) corporations that generate less than $26 million in average annual gross receipts, owned by a foreign parent, may not realize that they must consider their foreign parent’s gross receipts in the application of the [gross-receipts] test.” Multinational businesses therefore should carefully consider whether the aggregation rules may trigger the application of unfavorable tax rules for their U.S. subsidiaries.

Editor Notes

Mark Heroux, J.D., is a tax principal in the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago.

For additional information about these items, contact Heroux at mark.heroux@bakertilly.com.

Contributors are members of or associated with Baker Tilley US, LLP.