For many years, international tax planners took great care to design global tax structures to avoid Subpart F. Now, in what is perhaps an unintended error, Subpart F appears to have been greatly expanded for many multinationals and particularly private equity investors. This potential expansion of Subpart F is a result of new share ownership attribution rules under the Tax Cuts and Jobs Act (TCJA) where U.S. taxpayers that were not considered U.S. Shareholders of certain foreign corporations for purposes of Subpart F may now be liable for those foreign corporation’s Subpart F income beginning in 2017.
The issue that is causing such concern is the repeal by the TCJA of IRC §958(b)(4). Prior to repeal, this Code section prohibited “downward” attribution of stock ownership from a foreign person to a U.S. person. This prevented what would otherwise be Subpart F income being attributed to a U.S. Shareholder via a foreign parent.
How exactly did IRC §958(b)(4) operate prior to repeal? Here is a quick example. In a typical Subpart F avoidance structure, foreign parent (FP) owns 80% of a foreign corporation (FORCO) and 100% of a U.S. corporation (USCO). USCO owns the remaining 20% of FORCO. Prior to repeal, USCO would not be considered a U.S. Shareholder of FORCO for purposes of Subpart F. As such, USCO never considered or included any of FORCO’s income that would have qualified as Subpart F income had FORCO been owned directly by USCO. Quite simply, the IRC §958(b)(4) rules prevented FORCO from ever being a Controlled Foreign Corporation (“CFC”) for U.S. tax purposes.
What has changed? After repeal of IRC §958(b)(4), USCO is, for purposes of determining U.S. Shareholder and CFC status, treated as owning all of FORCO’s stock. USCO now owns 20% directly and 80% constructively (via FP) under newly enacted IRC §318(a)(3) making it a U.S. Shareholder of FORCO and also making FORCO a CFC. As such, USCO is now liable for U.S. tax on 20% of FORCO’s Subpart F income. That’s a really bad answer from both an income inclusion and information reporting standpoint.
This example is not the only situation where this may cause a significant expansion of Subpart F. There are many others out there. In practice, every foreign structure involving a U.S. owner needs to be tested. That’s a tall order, but when the scope of how the repeal of IRC §958(b)(4) operates is considered it’s not something that can be reasonably ignored.
As if Subpart F expansion is not enough to worry about, this also impacts whether a taxpayer is a 10% or more U.S. Shareholder for purposes of calculating the Global Intangible Low Taxed Income (GILTI) inclusion.
The biggest problem is that we simply don’t know if this expansion has really taken place. We certainly do know that IRC §958(b)(4) is gone and we also know the statutory language of IRC §318(a)(3). Thus, the statutes tell us downward attribution is now the rule.
However, the legislative history behind the TCJA states that the repeal of IRC §958(b)(4) was not intended to cause a foreign corporation to be a CFC with respect to any U.S. Shareholder as a result of downward attribution under section 318(a)(3) to any U.S. person that is not a “related person” (as defined by IRC §958(d)(3)) to such U.S. Shareholder. This means that Congress intended this to apply solely to related parties, particularly those involved in inversion transactions, and not to unrelated parties. That’s both logical and simple enough to understand but it is not part of any statute, regulation, or even authoritative guidance for that matter.
Why hasn’t this been resolved by now? One could reasonably theorize that Treasury feels it lacks authority to limit the scope of these rules via regulation and that a legislative correction, i.e., congressional action, is required to implement the result described in the legislative history. Congress, on the other hand, will find it difficult to enact a comprehensive technical corrections bill in short order considering the scope of the TCJA. In the absence of regulations, technical corrections, or some authoritative guidance, it is extremely difficult to reconcile the statutory language with the intent articulated in the legislative history.
One piece of guidance by the IRS has been regarding Form 5471. You can see where that would be a nightmare under these rules. IRS Notice 2018-13 provides an exception to filing Form 5471 for certain U.S. Shareholders considered to own stock via downward attribution from a foreign person. The Notice also states that they intend to modify the instructions to the Form 5471 as necessary which has not yet occurred.
The uncertainly outlined above has left taxpayers searching for the right approach here. To say there is no good approach is an understatement. For now, here are some of the choices:
- Wait for a technical correction, regulation, or other clarifying authority to make clear the intent of these new rules.
- File 2017 returns taking a technical position in favor of the legislative intent – on the basis that no other guidance currently exists – and keep your fingers crossed that the position outlined in such legislative authority is ultimately adopted.
- Liquidate, or check-the-box, on your U.S. C Corporation that’s contributing to the CFC attribution to have it treated as a disregarded entity.
- Liquidate, or check-the-box, on the foreign subsidiary creating the Subpart F income to have it treated as a disregarded entity.
Not a lot of great choices there. However, one could have reasonably anticipated that there would be problems like this as a result of the speed at which the TCJA was enacted. In the meantime, taxpayers must make a choice and prepare for the possibility that these rules may stand as such.
Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at email@example.com or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.