IRS Takes Controversial Approach to Characterization of Separately Stated Item of Subpart F Income
After several months of internal debate and discussions, the IRS recently refused to issue a private letter ruling pertaining to the ability of a constructive U.S. shareholder of a controlled foreign corporation (CFC) to make a retroactive §962 election.1 The issue was not whether the U.S. shareholder satisfied the requirements for seeking retroactive relief under the §9100 regulations, as the IRS agreed that those requirements had been met.2 Rather, the issue was whether a U.S. shareholder that constructively owns a CFC through a 100 percent owned S corporation (which, for subpart F purposes, is characterized as a single-member partnership under §1373(a)) has an amount that is “included in his gross income under [s]ection 951(a)” when the partnership has such an inclusion.
The IRS is of the view that, despite the unambiguous language of §702(b), the clear legislative intent behind §962, and analogous guidance issued by the IRS, a constructive U.S. shareholder of a CFC does not have the ability to make a §962 election on the grounds that a separately stated item of §951(a) income under §702(a) is not equivalent to a direct inclusion of §951(a) income. Stated differently, the IRS ignored the “conduit” nature of §702(b) and argued that the U.S. shareholder did not have a §951(a) inclusion, but instead had a §702(b) inclusion of §951(a) income. According to the IRS, these are two entirely different things. This article will discuss the arguments raised by the IRS and the taxpayer in connection with the ruling and consider some of the potential ramifications of the IRS position with respect to other U.S. international tax provisions.
Controlled Foreign Corporations
In general, a CFC is a foreign corporation that is more than 50 percent owned (by vote or value) by U.S. shareholders.3 A “U.S. shareholder” is defined as a U.S. person (within the meaning of §957(c)) that owns directly (as defined in §958(a)(1)), indirectly (as defined under §958(a)(2)), or constructively (as defined under §958(b)) 10 percent or more of the CFC’s voting stock.4
For purposes of determining whether a foreign corporation is a CFC, the ownership by U.S. shareholders can be direct, indirect, or constructive. Once it is determined that a foreign corporation is a CFC, however, it is only those U.S. shareholders of the CFC that own (within the meaning of §958(a)) (i.e., directly or indirectly) stock in such corporation on the last day in such year on which such corporation is a CFC that must include in their gross income 1) their pro rata share of the CFC’s subpart F income, and 2) the amount determined under §956 with respect to such shareholders for such year (§951(a) inclusions).5 In other words, constructive U.S. shareholders are not directly taxed on §951(a) inclusions.
The §962 Election and Deemed Paid Credit
Section 962 allows an individual (or trust or estate) U.S. shareholder of a CFC to elect to be subject to corporate income tax rates on amounts which are included in his or her gross income under §951(a). The purpose behind §962 is
to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. This provision gives such individuals assurance that their tax burdens, with respect to these undistributed foreign earnings, will be no heavier than they would have been had they invested in an American corporation doing business abroad.6
The §962 election accomplishes this result by allowing the U.S. shareholder to obtain an indirect foreign tax credit under §902 for a pro rata portion of any foreign taxes paid by the CFC.
Specifically, §962 provides that under regulations prescribed by the secretary, in the case of a U.S. shareholder who is an individual and who elects to have the provisions of this section apply for the taxable year: 1) the tax imposed under this chapter on amounts which are included in his gross income under §951(a) shall (in lieu of the tax determined under §§1 and 55) be an amount equal to the tax which would be imposed under §§11 and 55 if such amounts were received by a domestic corporation, and 2) for purposes of applying the provisions of §960 (relating to foreign tax credit) such amounts shall be treated as if they were received by a domestic corporation.
The U.S. federal income tax consequences of a U.S. individual making a §962 election are as follows. First, the individual is taxed on amounts included in his gross income under §951(a) at corporate tax rates. Second, the individual is entitled to a deemed-paid foreign tax credit under §960 as if the individual were a domestic corporation. Third, when the CFC makes an actual distribution of earnings that has already been included in gross income by the shareholder under §951(a), the earnings are included in gross income again to the extent they exceed the amount of U.S. income tax paid at the time of the §962 election.7
Sections 1373(a) and 702(b)
Section 1373(a) provides that “[f]or purposes of…subpart F [§§951 through 965],…an S corporation shall be treated as a partnership, and the shareholders of such corporation shall be treated as partners of such partnership.” Under §702(a)(7) and Treasury Regulation §1.702-1(a)(8)(ii), each partner is required to take into account separately the partner’s distributive share of any partnership item which, if separately taken into account by any partner, would result in an income tax liability for that partner, or for any other person, different from that which would result if that partner did not take the item into account separately.
Once the partner takes into account his or her distributive share of separately stated items, the regulations provide that the “character in the hands of a partner of any item of income, gain, loss, deduction, or credit described in §702(a)(1) through (8) shall be determined as if such item were realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership.” The legislative history to §702(b) further provides that
[section 702(b)] contains a “conduit” rule which makes clear that the character of any item realized by the partnership, and included in a partner’s distributive share, shall be the same as though he had realized such item directly, rather than through his membership in a partnership, from the source from which it was realized by the partnership and in the same manner.8
Facts of the Ruling
The relevant facts of the ruling are as follows. The taxpayer, a U.S. citizen and resident, owned 100 percent of the stock of a subchapter S corporation, which in turn owned 100 percent of the stock of a CFC organized in Hong Kong. The CFC was actively engaged in the business of selling electronic audio and video equipment on a wholesale basis.
In late 2006, the IRS began an examination of the S corporation’s tax return, which was expanded to include an examination of the taxpayer’s individual tax return. In January 2008, the IRS proposed an increased adjustment to the S corporation’s gross income in excess of $20 million for both taxable years combined, which reflected an investment of earnings in U.S. property by the CFC under §956(c)(1)(C) (i.e., obligations of a U.S. person) as a result of certain intercompany loans the CFC had made to the S corporation.
In order to mitigate the U.S. federal income tax consequences of having a §956 inclusion taxed at ordinary income rates without the benefit of a foreign tax credit, the taxpayer attempted to make a §962 election for the relevant tax years. Because the general three-year statute of limitations had expired, the taxpayer sought an extension of time under the §301.9100-3 regulations to file the election.
IRS’ Arguments
As noted above, the IRS rejected the ruling on the grounds that the sole shareholder of an S corporation that is in turn a U.S. shareholder of a CFC is not eligible to make a §962 election because such shareholder does not have an inclusion “under section 951(a).” The only authority cited by the IRS in support of this position was Textron v. Commissioner, 117 T.C. 67 (2001).
In February 1989, Textron, a U.S. corporation, acquired approximately 95 percent of the stock of Avdel, a U.K. company whose shares traded on the London Stock Exchange. Around this time, the Federal Trade Commission filed a complaint seeking to enjoin Textron’s acquisition and control of Avdel until certain potential trade issues could be resolved. Immediately thereafter, a court granted a temporary restraining order (TRO) enjoining Textron from assuming or exercising any form of direction or control over the assets or operations of Avdel.
Pursuant to the TRO, Textron transferred the Avdel stock to a voting trust pending resolution of the FTC issues. Textron was the sole beneficiary of the trust. The voting trust was a grantor trust for federal tax purposes under §677(a), which treats as an owner of a trust a grantor who retains certain rights to income from the trust. The parties agreed that Avdel was a CFC for federal income tax purposes.
The issue before the Tax Court centered on whether Textron was considered a “U.S. shareholder” of Avdel, and, therefore, required to include in its gross income a pro rata share of Avdel’s subpart F income pursuant to the CFC provisions. The IRS argued in Textron that because the trust was a grantor trust for federal tax purposes, Textron should be treated as owning the Avdel shares directly (i.e., the trust should be disregarded) and, therefore, be considered a “direct” U.S. shareholder under §958(a)(1)(A). Textron argued that because it could not vote the shares of Avdel (only the trustee of the trust could), it should not be considered a U.S. shareholder under the CFC rules.
Initially, the Tax Court noted that not every U.S. shareholder of a CFC must include in its gross income a pro rata share of the CFC’s subpart F income. Rather, inclusion applies only to those U.S. shareholders who own (within the meaning of §958(a)) stock directly or indirectly in such corporation on the last day, in such year, on which such corporation is a CFC. That is, as opposed to the broader definition of “U.S. shareholder” under §951(b), which is someone who owns directly, indirectly, or constructively 10 percent or more of the voting power of a CFC, §951(a) requires that the shares be owned directly or indirectly within the meaning of §958(a) in order for the subpart F inclusion to apply. Under §958(a), only stock owned through foreign entities is treated as owned indirectly by U.S. shareholders of a CFC. Thus, the court reasoned that a taxpayer who owns no stock through a foreign entity will be taxed under the CFC rules only if the taxpayer is a U.S. shareholder who directly owns stock in the CFC.
The Tax Court held that Textron did not directly own the Avdel shares — the trust did. Accordingly, the court did not disregard the existence of the trust, but rather treated it as a separate entity for federal tax purposes. As a result, the trust was the only U.S. shareholder that “owned” (within the meaning of §958(a)) stock in a CFC, and, therefore, was required to include in its gross income its share of Avdel’s subpart F income. Nevertheless, the Tax Court held that, due to the combined operation of subpart F and subpart E, “[the taxpayer], and not the …trust, [had to] include the trust’s … subpart F income in [the taxpayer’s] income.” The ultimate effect of the court’s holding, and the outcome of the central issue in the case, was to require inclusion of subpart F income in the constructive shareholder’s hands.
Relying on Textron, the IRS argued for purposes of the ruling that the taxpayer, a constructive U.S. shareholder under §958(b), was not eligible to make a §962 election because it did not have an inclusion under §951(a); rather the S corporation had an inclusion under §951(a) and the taxpayer had a corresponding inclusion under subchapter K. The IRS did concede that even under its logic, the taxpayer had a §702(b) inclusion of §951(a) income, but took the position, without providing any support, that a separately stated item of §951(a) income passed through to a partner under §702(a) is not the equivalent of a direct §951(a) inclusion for §962 purposes.
Taxpayer’s Arguments
The IRS argument suffers from a number of notable weaknesses. As noted earlier, for subpart F purposes, an S corporation is treated as a partnership. Under the partnership rules, each partner is required to take into account separately the partner’s distributive share of any partnership item which, if separately taken into account by any partner, would result in an income tax liability for that partner, or for any other person, different from that which would result if that partner did not take the item into account separately.
Once the partner takes into account its distributive share of separately stated items, §702(b) provides that the character in the hands of a partner of the distributive share of any item of income is “required to be determined as though he had realized such item directly, rather than through his membership in a partnership, from the source from which it was realized by the partnership and in the same manner.” (Emphasis added.) Because the S corporation (taxed as a partnership) clearly had an inclusion under §951(a), and §702(b) specifically requires the partners of a partnership to treat their distributive shares of partnership income as though such items were realized directly from the source, rather than through their membership in the partnership, it is difficult to comprehend how the taxpayer could be considered to realize anything other than a §951(a) inclusion in this case. Significantly, every known piece of commentary on this subject has opined in favor of the taxpayer’s position, concluding that partners or S corporation shareholders who are U.S. shareholders in a CFC pursuant to §958(b) should be permitted to make §962 elections.9
The IRS argument that a §702(b) inclusion of §951(a) income is not equivalent to having a direct §951(a) inclusion for §962 purposes is fundamentally flawed. The legislative history to §962 makes it clear that the purpose of such provision is to prevent hardship to certain individual U.S. shareholders who are taxable upon subpart F income that they do not receive. It should not matter through what chain of ownership such an individual is taxed; what matters is that the individual is so taxed, and that inconsistent tax results will otherwise be realized with respect to that individual vis-à-vis other similarly situated individuals.
Disregarding the Single-member Partnership Under §1373(a)
Section 1373(a) states that for certain purposes (including subpart F), S corporations are to be treated as partnerships, and the shareholders of such corporations are to be treated as partners. In the taxpayer’s case, the S corporation that causes the taxpayer to be a constructive U.S. shareholder pursuant to §958(b) was wholly owned by the taxpayer and, therefore, treated as a single-member partnership under §1373(a). definition, a partnership must generally be comprised of at least two partners.10 Consequently, the taxpayer argued (to no avail) that the partnership should be disregarded for U.S. federal income tax purposes. Under this reasoning, the taxpayer should have been treated as a direct U.S. shareholder of the CFC, thereby directly including in income under §951(a) his pro rata share of subpart F income. For reasons that are unclear, the IRS did not agree with this analysis.
Analogous IRS Authority Supporting Taxpayer’s Position
In addition to the language of §702(b) and the legislative intent behind §962, analogous guidance in other areas of the law support the taxpayer’s position.11 For example, in Rev. Rul. 71-141,12 two domestic corporations collectively owned, through their respective equal general partner interests in a domestic general partnership, 40 percent of the outstanding stock in a foreign corporation. The ruling addressed the question of whether the domestic corporations were eligible for §902 deemed paid tax credits with respect to their proportionate shares of the taxes paid to the foreign country in which the foreign corporation was resident. Section 902, as in force at that time, did not speak to the issue of indirect ownership, but permitted a credit to be taken by any “domestic corporation which owns 10 percent or more of the voting stock of a foreign corporation from which it receives dividends….” The ruling concluded that since §702(a) requires that each partner take into account a pro rata share of the partnership’s foreign tax liability, and each of the partners owned, indirectly through the partnership, at least 10 percent of the stock of the foreign corporation as required by §902, the domestic corporations were entitled to credit under §902 for their distributive shares of foreign taxes deemed to have been paid with respect to dividends received from the foreign corporation through the domestic partnership.13
Ramifications of IRS Position
• Section 512(b)(17) — If individual partners are not permitted to make §962 elections because they are not considered by the IRS to be taxed on “amounts which are included in … gross income under section 951(a),” as stated in the text of §962, this position will open the door to many abusive transactions achievable by simple insertion of a partnership into an ownership chain. For example, §512(b)(17) uses identical language, stating that any amount “included in gross income under Section 951(a)” is required to be characterized as unrelated business taxable income (UBTI) to a tax-exempt organization to the extent such income is attributable to §953 insurance income. If it is not possible for a person that owns an interest in a CFC through a domestic partnership to have amounts “included in gross income under section 951(a)” under the Textron-type analysis, then avoiding §512(b)(17) UBTI characterization as to insurance income is achievable by simply inserting a domestic partnership between the CFC and the exempt organization.14 This cannot have been the intent of Congress with respect to the quoted language, but unintended results such as this will undoubtedly come about as a result of the IRS position taken in the ruling.
• Section 904(d)(3)(B) — Section 904(d)(3)(B) provides one of several look-through rules for foreign tax credit limitation purposes, in this case with respect to subpart F inclusions, providing that “any amount included in gross income under section 951(a)(1)(A)” is treated as passive category income to the extent attributable to passive category income in the CFC’s hands. If, according to the IRS, it is not possible for a U.S. shareholder that owns an interest in a CFC through a domestic partnership to have amounts “included in gross income under section 951(a),” then this rule does not apply to such shareholders, and the Congressional intent of the provision cannot be achieved in such instances. It is highly doubtful that Congress would agree with such an interpretation.
• Section 904(h)(1) — Special source rules are provided with respect to “any amount included in gross income under. . . section 951(a) (relating to amounts included in gross income of United States shareholders)” for purposes of the foreign tax credit limitation under §904. Such amounts are treated as U.S. source income, notwithstanding that they would otherwise be treated as being from foreign sources, if they are attributable to income of a “United States-owned foreign corporation” that is from U.S. sources.15 If, according to the IRS, it is not possible for a U.S. shareholder that owns an interest in a CFC through a domestic partnership to have amounts “included in gross income under section 951(a),” then this rule also does not apply to such shareholders, and no re-sourcing of income will be effectuated. This outcome would clearly be at odds with congressional intent.
• Notice 2009-7 — The IRS recently issued Notice 2009-7,16 in which it identified as a “transaction of interest” a type of transaction in which a U.S. shareholder of CFCs, that in turn own stock in lower-tier CFCs through a domestic partnership, takes the position that subpart F income of the lower-tier CFC or an amount determined under §956(a) does not result in income inclusions under §951(a) for the U.S. taxpayer. According to the notice, “the IRS and Treasury Department believe that the position there is no income inclusion to [t]axpayer under [s]ection 951 is contrary to the purpose and intent of the provisions of subpart F of the [c]ode.”17
Thus, in Notice 2009-7, the IRS seems to be acknowledging that it does not believe taxpayers should be able to avoid having income included under §951(a) simply by inserting a domestic partnership into a structure. In fact, the IRS and Treasury specifically stated in the preamble to the final Brown Group regulations that “[t]o allow [taxpayers] to avoid subpart F treatment for items of income through the simple expedient of receiving them as distributive shares of partnership income, rather than directly, is contrary to the intent of subpart F.”18 Apparently the IRS only shares this view when the result benefits them.
Conclusion
Section 962 was enacted to promote equity; it is anomalous to interpret this law in a way that causes individual taxpayers to be taxed unequally on identical amounts. Every individual U.S. person who is taxable on subpart F income, whether that income is earned directly through a CFC, indirectly through a foreign partnership, “constructively” though a domestic partnership or S corporation, or by some other means, should be taxed in an equal manner. Section 962 exists to accomplish precisely this. Consequently, the IRS and Treasury should strongly consider issuing guidance 1) specifically allowing constructive U.S. shareholders of CFCs who pay tax on §951(a) inclusions to make §962 elections, and 2) addressing the characterization of a separately stated item of §951(a) income for U.S. federal income tax purposes, in all contexts.
1 All references to “section” refer to sections of the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder.
2 Treas. Reg. §301.9100-3 allows the IRS to grant extensions of time to file certain regulatory elections if the taxpayer acted reasonably and in good faith, and the grant of relief will not prejudice the interests of the government.
3 I.R.C. §957(a).
4 I.R.C. §951(b).
5 I.R.C. §951(a).
6 S. Rep. No. 1881, 87th Cong., 2d Sess. (1962), reprinted at 1962-3 C.B. at 798.
7 I.R.C. §962(d); Treas. Reg. §1.962-3. The most obvious reason why a taxpayer would choose to make a §962 election is the ability to defer the U.S. federal income tax on the actual distribution from the CFC, as well as the possibility of obtaining “qualified” dividends under §1(h)(11) on the subsequent distribution.
8 H. Rept. No. 1337, 83d Cong., 2d Sess., p. 222; and S. Rept. No. 1622, 83d Cong., 2d Sess., p. 377 (emphasis added).
9 See, e.g., Kuntz & Peroni, U.S. International Taxation, Part B (Taxation of U.S. Persons with Foreign Activities), ¶B 7.08[3][d]; Davis & Lainoff, U.S. Taxation of Foreign Joint Ventures, 46 Tax L. Rev. 165, 278-279 (1991); BNA Tax Management, U.S. Income Portfolios, 731-2nd (S Corporations: Operations), VIII. Foreign Operations, B.3.a., n. 1461; BNA Tax Management, Foreign Income Portfolios, 930-2nd, V.E.1; BNA Tax Management, Foreign Income Portfolios, 902-2nd, B; Robert C. Boffa, §962: Relief for U.S. Shareholders: How to Make the Election, Its Effects, When to Use It, Journal of Taxation, Taxation of International Trade (July 1973). See also Letter from Thomas A. Stout, Jr., of Vinson & Elkins, to Peter Daub, Office of International Tax Counsel, Treasury, 87 TNT 82-40 (April 15, 1987).
10 See Rev. Rul 99-6, 1999-1 C.B. 432; Edwin E. McCauslen v. Commissioner, 45 T.C. 588 (1966); Rev. Rul. 67-65, 1967-1 C.B. 168; Rev. Rul. 55-68, 1955-1 C.B. 372. See also Treas. Reg. §301.7701-3(b)(1).
11 In addition, in Notice 2005-64, the IRS stated that “[f]or purposes of §965(b)(2)(B), amounts includible under §951(a)(1)(B)…in the gross income of a domestic partnership that was owned by a U.S. shareholder during a base period year shall be treated as includible in the U.S. shareholder’s income under §951(a)(1)(B)…to the extent the includible amount was (i) allocated to the U.S. shareholder-partner under the rules of §§702 and 704 and the regulations thereunder in a base period year; and (ii) separately stated to the partner under Treas. Reg. §1.702-1(a)(8)(ii).” Notice 2005-64, §10.02, 2005-2 C.B. 471. Moreover, the IRS made a similar argument in the partnership context in TAM 200437033.
12 1971-1 C.B. 211.
13 In 2004, Congress affirmatively expanded the reach of §902 by amending the provision to include a new paragraph (c)(7) (“constructive ownership through partnerships”). See H. Rep. No. 755, 108th Cong., 2d Sess. (2004).
14 But see PLR 200623069.
15 I.R.C. §904(h)(1), (2).
16 2009-3 I.R.B. 312.
17 Id. (emphasis added).
18 T.D. 9008, 2002-33 I.R.B. 335.
Jeffrey L. Rubinger is a tax partner in Holland & Knight’s Ft. Lauderdale office and is head of its south Florida tax practice. He received his J.D. from the University of Florida School of Law and an LL.M. in taxation from New York University School of Law. Mr. Rubinger is admitted to the Florida and New York bars and is a certified public accountant.
Summer A. LePree is a tax associate in Holland & Knight’s Miami office. She received her J.D. and LL.M. in taxation from the University of Florida School of Law. Ms. LePree is admitted to The Florida Bar.
This column is submitted on behalf of the Tax Section, Frances D. McCoid Sheehy, chair, and Michael D. Miller and Benjamin Jablow, editors.
