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Navigating the U.S. tax rules when starting or expanding a business overseas Lawrence Pollack, KPMG LLP David Shapiro, Shapiro Tax Law LLC NYU 71 st Institute.

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Presentation on theme: "Navigating the U.S. tax rules when starting or expanding a business overseas Lawrence Pollack, KPMG LLP David Shapiro, Shapiro Tax Law LLC NYU 71 st Institute."— Presentation transcript:

1 Navigating the U.S. tax rules when starting or expanding a business overseas Lawrence Pollack, KPMG LLP David Shapiro, Shapiro Tax Law LLC NYU 71 st Institute on Federal Taxation New York, NY – October 22, 2012 San Diego, CA – November 12, 2012

2 Disclaimer ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY ANY PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. ©2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ("KPMG International"), a Swiss entity, and Shapiro Tax Law LLC, a Pennsylvania limited liability company. All rights reserved. 2

3 Agenda Branch versus subsidiary Later conversion of foreign branch into foreign subsidiary Maintaining U.S. tax deferral by navigating the anti-deferral regimes – Subpart F – Investment in U.S. property – Passive foreign investment company 3

4 Branch operations True foreign branch versus “check the box” hybrid branch U.S. tax benefits of operating as a foreign branch – Often considered when local operations would not cause a taxable presence in foreign jurisdiction – Start-up losses currently deductible in the U.S., subject to the dual consolidated loss rules – Some foreign countries do not impose a branch remittance tax, but do impose a dividend withholding tax on profit repatriation U.S. tax disadvantages of operating as a foreign branch – Profits currently taxable in the U.S. – Foreign tax credit limitations may be more difficult to manage with branch rather than subsidiary form 4

5 Incorporation of foreign branch – Potential loss recapture U.S. tax loss recapture provisions to evaluate – Branch loss recapture. IRC §367(a)(3)(C) – Dual consolidated loss recapture. IRC §1503(d) – Overall foreign loss recapture. IRC §904(f) Incorporation when foreign branch achieves “cumulative” break even point can avoid loss recapture 5

6 Deferring U.S. tax on foreign subsidiary earnings – Avoiding direct and indirect U.S. taxation Avoiding U.S. effectively connected income and U.S. permanent establishment Subpart F – Foreign Personal Holding Company Income – Foreign Base Company Sales Income – Foreign Base Company Services Income – Other Investment in U.S. property Passive foreign investment company 6

7 Overview – Subpart F exception to deferral Certain income of a controlled foreign corporation (CFC) is currently includible in the income of its U.S. shareholders in the year earned – Inclusion creates increased tax basis in the CFC shares under IRC §961(a) – Amounts distributed by the CFC in current and subsequent taxable years treated first as "previously taxed income" under §959, and reduce U.S. shareholder's U.S. tax basis in the CFC shares under §961(b) Earnings of a CFC invested in "U.S. property" under sec. 956 treated as currently distributed to its U.S. shareholders per sec. 959 IRC Sec. 951(a)(1) 7

8 Subpart F – Statutory provision IRC §951(a)(1) provides that if: a foreign corporation is a controlled foreign corporation ("CFC") for an uninterrupted period of 30 days or more during any taxable year every person who is a "U.S. shareholder" (as defined in §951(b)) of such corporation and who owns, within the meaning of §958(a), stock in such corporation on the last day (in such taxable year) on which the corporation is a CFC shall include in his gross income his pro rata share of the corporation's subpart F income for the year and the amount of Investment in U.S. property as determined under section 956 8

9 "Hopscotch" rule for subpart F inclusion U.S. Inclusion CFC-1 CFC-2 Subpart F income 9

10 Definition of "U.S. Shareholder" 10% of voting power of FC stock (owned directly, indirectly, or constructively) Value of stock is irrelevant IRC Sec. 951(b), 958, 318 9% voting stock 100% nonvoting preferred stock FC U.S. 10

11 Definition of controlled foreign corporation (“CFC”) A foreign corporation is a CFC if more than 50 percent of the total combined voting power or total value of the stock of such corporation is owned (directly, indirectly, or constructively) by U.S. shareholders on any day during the tax year of such corporation. Attribution FROM entities: – From partnerships and estates (and, generally, trusts): proportionately to partners and beneficiaries – From corporations: proportionately to 10% or greater shareholders – Special rule – If an entity owns > 50% voting power in another corporation, it is treated as owning 100% of such entity, solely for purpose of the "attribution from entity" rule. Attribution TO entities Family attribution IRC Sec. 957(a), 958, 318, Regs

12 Example: Special 50% Rule Attribution from Entities Is Foreign Corporation a CFC? – U.S. partner "indirectly" owns 36% voting power of FC (60% of 60%). – However, since foreign partnership owns more than 50% voting power in FC, it is treated as owning 100% solely for purposes of applying attribution from entity rule. As such, U.S. partner treated as "constructively" owning 60% of 100% of FC, thus causing FC to be a CFC under special rule. – The subpart F inclusion is based on 36% indirect ownership. IRC Sec. 958(b)(2) 60% Voting Power Foreign Corporation Foreign Corporation U.S. Partner U.S. Partner 60% Voting Power Foreign Partnership 12

13 U.S. partnership "blocker”: Notice Treasury and IRS intend to issue regulations that would classify certain domestic partnerships as foreign partnerships solely for purposes of identifying the U.S. shareholders of a CFC that are required to include subpart F (and section 956) income Intended to prevent use of a U.S. partnership with foreign corporate partners, and with ultimate U.S. ownership to hold shares of a CFC with a view towards avoiding subpart F inclusion IRS stated this structure is "manifestly incompatible with the intent of §951". 13

14 Notice : Partnership blocker U.S. partnership would be treated as a foreign partnership for purposes of determining the U.S. shareholder that has a subpart F inclusion where : The partnership is a U.S. shareholder of a foreign corporation that is a CFC, and If the partnership were treated as foreign, – that foreign corporation would continue to be a CFC, and – at least one U.S. shareholder of the CFC would be treated under §958(a) as indirectly owning stock of the CFC owned by the partnership that is indirectly owned by a foreign corporation, and would be required to include an amount in gross income under §951(a) with respect to the CFC CFC-1 CFC-2 100% U.S. CFC-3 U.S. Ptp 100% 50% 100% 14

15 Subpart F Income Insurance income Foreign base company income International boycott factor Bribes, kickbacks, or illegal payments to government officials Income from certain blacklisted countries designated in accordance with IRC §901(j) IRC Sec. 952(a); 75 F.R , 7/29/10; Rev. Rul

16 Exclusions and Limitations Effectively connected income Current earnings and profits limitation Qualified deficits Recharacterization in later years under IRC Sec. 952(c)(2) IRC Sec. 952(b), (c). 16

17 Foreign Base Company Income (“FBCI”) Foreign personal holding company income Foreign base company sales income Foreign base company services income Oil related income IRC Sec. 954(a). 17

18 Special Rules and Exceptions to Foreign Base Company Income Full inclusion rule – All income treated as foreign base company income or insurance income if FBCI and insurance income exceed 70% of the CFC's total gross income De minimis rule – No income treated as FBCI if sum of FBCI and insurance income is less than lesser of: 5% of the CFC’s gross income, or $1 million High tax exception – CFC’s foreign base company income taxed at a rate greater than 90% of maximum U.S. rate (currently 31.5%), determined using U.S. tax principles IRC Sec. 954(b)(3)(B), (b)(3)(A) and (b)(4). 18

19 Foreign Personal Holding Company Income (“FPHCI”) Dividends, interest, royalties, rents, and annuities – Exclusion for "PTI" dividends Excess of gains over losses from disposition of property that produces FPHCI – Capital gains from disposition of stock, bond, patent – May avoid by "check and sell" transaction Excess of gains over losses from certain commodities transactions Excess of foreign currency gains over losses from Sec. 988 transactions Others (i.e., income equivalent to interest) IRC Sec. 954(c), 959(b). 19

20 FPHCI – Dividends Exclusion for same country dividends IRC Sec. 954(c)(3). Year One Year Two (internal reorganization ) Same country exclusion only applies if earnings are attributable to recipient's holding period in payor's stock U.S. Y Y X X Dividends U.S. NEWCO – Y Y Y X X 20

21 FPHCI – Gains from Property Transactions Property transactions – FPHCI includes net gains from sale or exchange of: – Property that gives rise to FPHCI – An interest in a trust, partnership or REMIC Exception for sale by CFC of 25% or greater interest in partnership (look- through treatment) – Property that does not give rise to any income (e.g., gold, options) FPHCI does not include gains and losses from the sale or exchange of inventory- type property or assets used in business operations, including sale of goodwill or going concern value. IRC Sec. 954(c)(1)(B), 954(c)(4). 21

22 2005 Tax Act – Temporary "CFC look-through" exception to FPHCI The 2005 Act provides a temporary "CFC look-through" exception from subpart F FPHCI for dividends, interest, rents, and royalties received by a CFC from another CFC that is a related person within the meaning of §954(d)(3) – A "related" CFC is a CFC that controls or is controlled by the other CFC, or a CFC that is controlled by the same person or persons that control the other CFC – Ownership of more than 50% of the CFC's stock (by vote or value) constitutes control Notice

23 2005 Tax Act – Temporary "CFC look-through" exception to FPHCI – cont. To the extent such items (of dividends, interest, rents, or royalty) are attributable or properly allocable to income of the related CFC that is not subpart F income, they are not treated as FPHCI to the recipient CFC Effective for tax years of CFCs beginning after December 31, 2005 and before January 1, 2012 (as extended by the Unemployment Insurance Reauthorization and Job Creation Act of 2010) Most recent proposal to extend the look-through provision for two years has been approved by the Senate Finance Committee and will be considered in the fall of Notice

24 FPHCI planning to avoid subpart F through use of “foreign reverse hybrid entity" Exclusion for same country interest IRC Sec. 954(c)(3)(A)(i). Country X Opco Country X Partnership Loan Equity Reverse Hybrid U.S. Parent U.S. Parent 24

25 FPHCI Planning – CTB election to facilitate cash deployment Often, check the box (CTB) elections are made to facilitate redeployment of cash within a multinational group while avoiding subpart F CTB elections enable dividend flows to be treated instead as branch remittances, which are not treated as FPHCI subpart F dividend income CFC Holding U.S. CFC Opco DividendsBranch remittances CFC Opco 25

26 FPHCI Planning – "Check & Sell" Transaction U.K. Holding makes a "check the box" ("CTB") election to disregard U.K. Opco, effective just before U.K. Holding sells shares of U.K. Opco Tax Court held for the taxpayer that the transaction should be treated for U.S. tax purposes as a sale by U.K. Holding of the assets (rather than the shares) of U.K. Opco Hence, subpart F FPHCI gain was avoided Dover Corporation & Subsidiaries vs. Commissioner, 122 T.C. 324 (2004). U.S. U.K. Holding U.K. Opco U.S. U.K. Holding U.K. Opco 26

27 The “Excess Return” Proposal Obama Administration’s FY 2012 and 2013 Budget Proposals to impose a current U.S. tax on “excess returns” associated with transfers of intangibles to a CFC – “Excess returns” on intangibles transferred by a U.S. person to a related CFC that is subject to a low foreign effective tax rate would be treated as subpart F income (in a separate FTC limitation basket) Under the proposal, in the case of an effective tax rate of 10% or less, all excess income from a ‘covered intangible’ would be treated as Subpart F income, and would then phase out ratably for effective tax rates of 10 to 15%. Such excess income will be calculated based upon the gross income from transactions connected with or benefitting from such covered intangible over the costs plus a mark-up attributable to such gross income. Transfers would include sales, leases, and licenses as well as “any shared risk or development agreement (including any cost sharing agreement)” 27

28 Foreign base company sales income Three essential elements: 1.CFC engages in certain related-party transactions associated with the buy/sell process regarding personal property (“goods”) 2.Goods manufactured outside country of CFC's incorporation, and 3.Goods sold for use, consumption, or disposition outside CFC's country of incorporation IRC Sec. 954(d). 28

29 FBC sales income – Related-party transactions CFC engaged in sales operations: CFC buys personal property from related party and sells it to any person (and derives a trading profit), or CFC sells personal property to any person on behalf of related party (and earns a sales commission) CFC engaged in purchasing operations: CFC buys personal property from any person and sells it to related party (and derives a trading profit), or CFC buys personal property from any person on behalf of related party (and earns a buying commission ) IRC Sec. 954(d); Regs (a)(1)(i). 29

30 FBC sales income – CFC selling agent IRC Sec. 954(d). U.S. Parent manufactures personal property and sells to its Cayman CFC at arm's length. Cayman CFC resells to Swiss customers (or sells to Swiss customers on behalf of U.S. parent and earns a sales commission) Swiss Customers Cayman CFC Cayman CFC U.S. Resale Sale 30

31 FBC sales income – CFC buying agent IRC Sec. 954(d). Cayman CFC purchases goods from unrelated Swiss manufacturers for resale to U.S. parent (or Cayman CFC purchases goods from Swiss manufacturer on behalf of U.S. parent, and earns a buying commission from U.S. parent) Swiss manufacturers Cayman CFC Cayman CFC U.S. Purchase Re-sale 31

32 FBC sales income – Exceptions Agricultural commodities not grown in commercially marketable quantities in the U.S. – Bananas, black pepper, cocoa, coconut, coffee, crude rubber, and tea. Manufacture in country of CFC's incorporation (by anyone) Goods sold for use, consumption, or disposition in country of CFC's incorporation Manufactured by CFC (anywhere) – Perhaps via contract manufacturing – Substantial contribution test – regulations contain seven nonexclusive factors that may be considered Effective for tax years beginning after June 30, 2009 IRC Sec. 954(d)(1); Regs (a)(1), (2), (3) and (4). 32

33 "Manufactured" – Physical manufacturing tests CFC will be treated as having manufactured personal property if through the activities of its employees: – The personal property purchased by the CFC is "substantially transformed" by the CFC prior to its sale – Purchased components – subjective test – sale of personal property will be treated as sale of a manufactured product rather than sale of component parts if the assembly/conversion activities are substantial and generally considered to constitute "manufacture" of property – Purchased components – safe harbor – conversion costs (direct labor and factory burden) of the CFC account for 20% or more of the total cost of goods sold However, in no event will packaging, labeling, or minor assembly operations constitute the manufacture of property for purposes of §954(d)(1). Regs (a)(4); Bausch and Lomb, T.C. Memo

34 "Manufactured" – Substantial contribution test Applies where CFC does not itself sufficiently engage in the physical manufacturing process and therefore does not satisfy the physical manufacturing test, but through its own employees makes a "substantial contribution" to the manufacture of personal property (i.e., through contract manufacturer) Seven nonexclusive factors are provided – Overall facts and circumstances subjective test – No single activity is provided more weight than others 34

35 "Manufactured" – Substantial contribution test – Seven factors Oversight and direction of the manufacturing activities or process Performance of some manufacturing activities Material selection, vendor selection, or control of raw materials, work in process, or finished goods Management of manufacturing costs or capacities (including management of the risk of loss, cost reduction, etc.) Control of manufacturing-related logistics Quality control Developing or directing development of product design and design specifications or IP used in the manufacturing of personal property 35

36 FBC sales income – Sales branch rule Sales branch rule treats branch as a related party subsidiary of CFC if branch income is subject to effective rate of tax that is less than 90% of, and at least 5 percentage points less than, the tax rate that would apply to such income in CFC's country of incorporation. IRC Sec. 954(d)(2); Regs (b)(1)(i). Netherlands CFC U.S. 15% tax rate Swiss sales branch 25.5% tax rate 36

37 FBC sales income – Manufacturing branch rule Manufacturing branch rule treats branch as a related party subsidiary of CFC if income of the remainder of the CFC (i.e., head office) is subject to effective rate of tax that is less than 90% of, and at least 5 percentage points less than, the tax rate that would apply to such income in country where the branch is located. IRC Sec. 954(d)(2); Regs (b)(1)(ii). Netherlands CFC U.S. 33% tax rate French manufacturing branch 25.5% tax rate 37

38 Sales branch rule – Purchasing in CFC's home country and selling through low-taxed sales branch Sales branch rule would apply where a Dutch CFC has employees in the Netherlands who purchase goods from unrelated parties and resell the goods to unrelated parties through its low-taxed sales branch in Switzerland. Dutch CFC would have FBC sales income to the extent the goods are manufactured (by another) and sold for use outside the Netherlands. Swiss sales branch (fictional CFC) would also have FBC sales income to the extent the goods are manufactured (by another) and sold for use outside of Switzerland. Netherlands CFC U.S. 15% tax rate Swiss Sales Branch 25.5% tax rate 38

39 Sales branch rule not applied – Manufacturing/sales branch Sales branch rule does not apply where a CFC has a foreign manufacturing branch that also sells the property manufactured. In such case, the manufacturing exception would apply to avoid FBC sales income. Regs (a)(2) and (4); T(b)(2)(ii)(e); (b)(4), example 3, TAM and PLR Netherlands CFC U.S. 15% tax rate Swiss manufacturing & sales branch 25.5% tax rate 39

40 Sales branch rule not applied – Purchasing and selling through one branch Sales branch rule does not apply where a CFC has a foreign trading branch that purchases finished products from unrelated suppliers and sells the products to unrelated customers, where all purchasing and selling activities occur in country where branch is located. Regs T(b)(2)(i)(b); & (ii)(b); (b)(4), example 3. Netherlands CFC U.S. 15% tax rate Swiss purchasing & sales branch 25.5% tax rate 40

41 FBC services income Foreign base company services income includes income derived by a CFC from the performance of services if the services are performed: – for or on behalf of a related party, and – outside the CFC's country of its incorporation. IRC Sec. 954(e); Regs

42 "For or on Behalf of" Regulations include four nonexclusive situations in which a CFC is treated as performing services "for or on behalf of" a related party: 1.CFC is paid by a related person for performing services. 2.CFC performs services which a related person is, or has been, obligated to perform. 3.CFC performs services with respect to property sold by a related person, and the performance of such services by the CFC constitutes a condition or material term of such sale by the related person. 4.CFC receives substantial assistance furnished by a related U.S. person in the performance of the CFC's services. Regs (b). 42

43 Example – CFC Paid by Related Person CFC has a separate service contract with unrelated customer. USP pays CFC for installation and maintenance services Result: CFC's services are considered performed "for or on behalf of" a related person since CFC is paid by a related person USP Customer Install and maintain machines CFC Manufacture and sell machines Service Fee 43

44 Example – Related Person Obligated to Perform Services USP assigns construction contract to CFC. Customer releases USP from contract Result: CFC's services are considered performed "for or on behalf of" a related person because USP, a related person, had been obligated to perform such services. Would not have been "for or on behalf of" a related person if CFC had been the original contract party USP Customer CFC Construction Contract Assignment of Contract 44

45 Services are a condition or material term of a related person property sale USP sells machine to customer for special reduced price on condition that customer agrees to employ and pay CFC for installation services. Result: CFC considered to perform services for, or on behalf of, a related person since the services that it performs are a condition or material term of a related-person property sale. If installation contract were truly independent of machine sale, would not be FBC services income. USP Customer CFC Manufactures and sells industrial machine Installation services 45

46 “Substantial assistance” furnished by related U.S. person Under certain circumstances, services performed by a CFC will be treated as performed for or on behalf of a related person where a U.S. related person furnishes "substantial assistance" to the CFC contributing to the performance of services by the CFC. Result: FBC services income results if CFC's services are rendered outside country of its incorporation. Note: “Substantial assistance" from another CFC will not in itself trigger FBC services income However, payments to other CFC could be FBC services income in the hands of the other CFC. Regs (b)(1)(iv); Notice

47 Substantial Assistance Assistance furnished by a related U.S. person includes direction, supervision, services, know-how, financial assistance (other than contributions to capital), and equipment, material, or supplies Assistance is considered substantial if the cost to CFC for U.S. related persons assistance is at least 80% of the total cost to CFC of performing the services Regs (b)(2)(ii); Notice , effective for taxable years of foreign corporations beginning after December 31,

48 “Commissions” for CFC’s sales/purchase efforts Commissions or fees derived by a CFC in connection with the purchase or sale of personal property on behalf of a related person is considered as sales income for purposes of applying the foreign base company sales income provision. However, income derived by a CFC from certain post-sales activities may in particular give rise to services (rather than sales) income, such as installation, maintenance or warranty services with respect to personal property sold by a related person. – This income would be tested for subpart F under the foreign base company services provisions rather than the foreign base company sales income provisions. IRC §954(d)(1); Regs. § (a)(1); (b)(3), Examples 1, 8 and 10; see also Reg. § (d). 48

49 Investment of Earnings in U.S. Property U.S. shareholders are taxed on pro rata share of CFC's investment of earnings in "U.S. property" – Referred to as a “section 956 inclusion" Amount of U.S. property is based on average of quarterly amounts held by CFC – Based on adjusted U.S. tax basis of property Amount of section 956 inclusion limited to "applicable earnings" amount – Applicable earnings are essentially earnings and profits (current and accumulated) of the CFC, less current distributions and less amounts of previously taxed section 956 inclusions that have not yet been distributed IRC Sec. 951(a)(1)(B); 956(a)(1)(A); 956(b)(1). 49

50 What is "U.S. Property"? Tangible property located in the United States Stock of a domestic corporation Obligations of a U.S. person Guarantee by a CFC of an obligation of a U.S. person – Includes pledge by U.S. shareholder of 2/3 or more of stock of a CFC together with certain negative covenants – Can include global debt facility with joint & several obligor provision to the extent U.S. domestic members draw down on debt facility Tantamount to CFC guarantee of U.S. parent's share of debt obligation Right to use intellectual property in the United States IRC Sec. 956(c); Regs (c). 50

51 Items Excluded from "U.S. Property" Obligations of the United States (e.g., U.S. Treasury bonds) Money and deposits with persons carrying on the banking business Property located in the United States which is purchased in the United States for export to, or use in, foreign countries Obligation of a U.S. person arising in connection with the sale or processing of property, provided the amount of such obligation does not exceed the amount which would be "ordinary and necessary" had the transaction been between unrelated persons IRC Sec. 956(c)(2). 51

52 Items Excluded from "U.S. Property" (continued) Obligations arising from CFC's provision of services to a U.S. person that are collected within 60 days (safe harbor) Stock or obligations of a domestic corporation which is not a U.S. shareholder of the CFC, provided that U.S. shareholders of the CFC do not control (directly, indirectly or constructively) 25% or more of the voting power of the domestic corporation Regs T(d)(2)(i)(B); IRC Sec. 956(c)(2)(F). 52

53 Items Excluded from "U.S. Property" – Short-term CFC Loans Obligations that are collected within 30 days from the time incurred provided that the 60-day aggregate test is not exceeded (Notice ) Temporary rule provided by Notice to facilitate liquidity – CFC may choose to exclude from U.S. property an obligation held by the CFC at quarter end that is collected within 60 days from the time it is incurred, so long as the CFC does not hold for 180 or more days during the year obligations that would otherwise constitute U.S. property – Effective only for the first two taxable years of a CFC ending after October 3, Notice extended application of Notice one additional year. See IRS generic legal advice, 2007 TNT , Sept 25,

54 IRS Disregard – Temporary Period of "Disinvestment" in U.S. Property Rev. Rul : – Situation one: CFC held an obligation of its U.S. Parent from February 5 until November 15 in year 1, and a new obligation of the same obligor from January 15 until November 10 in year 2 IRS ruled both loans would be collapsed and treated as a continuous loan outstanding at year end, thus triggering section day loan followed by 60-day disinvestment period – Situation two: CFC held an obligation of its U.S. Parent from February 1 until June 30 in year 1, and a new obligation of the same obligor from January 15 until November 15 in year 2 IRS ruled that the period of disinvestment between loans was sufficiently long to be respected 150-day loan followed by a 198-day disinvestment period 54

55 Series of Multiple Loans by CFC "Aggregated" as One Continuous Loan (substance vs. form) Series of 12 short-term loans by a CFC to its U.S. parent over 2 1/2 year period were collapsed as one continuous loan to USP Funds borrowed were within control of USP 94% of the 2 1/2 year period Court applied step transaction and substance over form doctrines Held: the series of short-term loan transactions were in fact a single loan lasting 2 1/2 years, thereby causing a 956 inclusion Jacobs Engineering Group, Inc. v U.S. 79 AFTR 2d (CD. CA 1997), affd. 168 F.3d 499 (4th Cir. 1999). 55

56 Passive Foreign Investment Company (“PFIC”) A foreign corporation is a PFIC if either – 75% or more of its gross income is “passive” (“income test”), or – At least 50% of its assets produce or are held for the production of passive income (“asset test”) IRC §1297; Notice

57 Passive Foreign Investment Company (“PFIC”) (continued) “Passive income” is defined as income which is of a kind that would be FPHCI under IRC §954(c) – Cash, and other assets that are readily convertible into cash, produce passive income and therefore are treated as passive assets, even if they are part of the working capital of an active business. In determining PFIC status, a look-through rule applies to measure proportionate share of gross income and assets of 25% owned corporations – Where look-through rule does not apply, shares are treated as a passive asset. No minimal level of U.S. ownership threshold, unlike subpart F and investment in U.S. property 57

58 PFIC – Income test Determined based on gross income Look-through rules for interest, dividends, rents and royalties from 25% or greater owned corporations Exclusions for: – Income derived in the active conduct of a banking business by an institution licensed to do business as a bank in the United States or under proposed regulations, any foreign bank that actively conducts a banking business, has substantial bona fide banking activities, and is licensed to take deposits in its country of charter or incorporation – Income derived in the active conduct of an insurance business by a company that would be taxed under subchapter L if it were domestic IRC § 1297(b) and (c), 1298(e), Notice 88-22, Notice 89-81, Prop. Reg. §

59 PFIC – Asset test Divide gross average passive asset amount by gross average total asset amount – Average determined based on quarter end asset amounts – Public companies: asset amount equals fair market value (including goodwill based on implied value from market capitalization) – Other companies: asset amount equals gross asset basis, with some adjustments for research expenses Receivables treated as active or passive based on character of income that generated the receivable Dealer’s inventory of stock or securities is nonpassive, provided it is specifically identified as inventory (versus investment) on its books and records IRC § 1297(e), Notice 88-22, Notice

60 PFIC – “Excess distributions” Unfavorable PFIC interest charge regime applies to “excess distributions” from a PFIC and gains recognized upon disposition of the shares of a PFIC Excess distribution is equal to the excess of amount of distribution received in current year over 125% of average distributions received from such PFIC in prior three years In case of gain recognized upon disposition of PFIC stock, entire gain treated as excess distribution IRC §

61 PFIC – Unfavorable consequences Excess distributions are subject to an interest charge referred to as a “deferred tax amount” – Deferred tax amount is calculated by treating the excess distribution as if it were realized on a ratable basis over shareholders entire holding period in the shares; amount allocable to post-1986 years subject to tax at maximum tax rates, plus interest charge – Maximum tax rates apply even if taxpayer is (or was) otherwise in NOL position for any of the taxable years in the holding period, as PFIC tax is computed independently from regular tax calculation Gains from disposition of PFIC shares may be subject to recognition regardless of applicability of non-recognition provision (e.g., reorganizations, etc.) IRC §1291; Prop. Regs. § (b). 61

62 “Qualified electing fund” election Avoids or limits the PFIC interest charge Requires current inclusion (by U.S. owners) of the ordinary income and capital gain of the PFIC – Reporting requirements may be seen as onerous by foreign managers/owners Not fully effective unless made in the first year the company is a PFIC – otherwise protects against excess distribution treatment only as to the income included after QEF election is in effect IRC §

63 Start-up and restructuring exceptions Start-up exception applies during first taxable year the corporation has gross income (the “start-up year”) if: – It is not a successor to a PFIC – It is not a PFIC in either of the two years immediately following the start-up year (i.e., its second and third taxable years) Restructuring exception applies during any taxable year when a company disposes of a business line (the “restructuring year”) if: – Neither the company nor any predecessor was ever a PFIC – Substantially all passive income is attributable to proceeds from disposition of one or more active trades or businesses – The company is not a PFIC during the two years immediately following the restructuring year IRC § 1298(b)(2), (b)(3). 63

64 CFC/PFIC Overlap Foreign corporation shall not be treated with respect to a shareholder as a PFIC for the portion of the holding period after 1997 during which the foreign corporation was a “CFC” and the shareholder was a “U.S. shareholder” as defined in IRC §951(b) with respect to the CFC. IRC §1297(d), 951(c). 64


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