Introduction

The crux of understanding the Subpart F taxation provisions is the distinction between a foreign corporation and a controlled foreign corporation. (1) The distinction relies upon the percentages of ownership of a foreign corporation and the definitional designation of who is regarded as a United States shareholder. (2)

It is the combination of a foreign corporate entity being characterized by statutory definition as a controlled foreign corporation and the shareholder or shareholders being United States shareholders. Those two elements result in a foreign corporation being subject to Subpart F Income treatment. Section 951 requires United States shareholders of a controlled foreign corporation to include in their gross income for a taxable year their pro rata share of Subpart F Income. (3) If one of these elements is eliminated, either the controlled status or the characterization of a shareholder as a United States shareholder, it eliminates the application of Subpart F Income rules to the shareholder or shareholders.

Subpart F Income

To gain a working command of Subpart F Income rules, it is productive to understand the factors that cause an entity to be characterized as a controlled foreign corporation. Understanding the ownership percentages that result in a shareholder being deemed a United States shareholder enhances the planning concepts. The ability to manage these two components of Subpart F Income affords various structural planning strategies in the organizational process.

In order for Subpart F Income rules to be applicable to a foreign corporation, the United States shareholders must by statute control the foreign corporation. A foreign corporation is construed by statute to be a controlled foreign corporation if United States shareholders have ownership of a foreign corporation in two ways:

1. If stock is owned and more than fifty percent ownership of the total combined voting power of all classes of stock entitled to vote, it is deemed a controlled foreign corporation.

2. If stock is owned by United States shareholders and more than fifty percent ownership of the total value of the stock issued by the foreign corporation is so held, it is deemed a controlled foreign corporation. (4)

For purposes of these determinations, stock that is indirectly or constructively owned by a United States shareholder is taken into account as though it were stock that is directly owned. (5) Because these ownership determinations are calculated on the basis of who is a United States shareholder, it is vital to understand how shareholders are determined to be United States shareholders and how the constructive ownership rules contribute to that ownership.

A United States shareholder by virtue of definition is a United States person who owns directly, indirectly, or constructively ten percent or more of the total combined voting power of all classes of stock that have been issued by a foreign corporation. (6) It is essential to note that in making percentage calculations of ownership rules, a distinction exists in how a percentage is calculated in the determination of a United States shareholder and a foreign corporation that is deemed controlled. Percentage ownership and value are both part of the calculation of the controlled foreign corporation status. Only ownership is tested in the determination of who by statute is a United States shareholder. This is an important planning tool in structuring corporate ownership to avoid controlled corporate status and the resulting application of Subpart F Income rules.

A United States shareholder is a United States person by definition. A United States person is a United States citizen or resident, a domestic corporation, a domestic partnership, a domestic estate or a domestic trust. (7) These definitions are precise and interrelated. The relationship between a United States shareholder and a controlled foreign corporation is established by these definitions.

A foreign corporation is a controlled foreign corporation only if fifty percent of all stock owned or the value of all stock owned is attributable to United States shareholders. On the other hand, United States shareholders, for purposes of determining which foreign corporate shareholders are United States shareholders, only account for those shareholders who own ten percent or more of the combined voting power of all classes of stock of a foreign corporation, not value. (8) A significant amount of importance should be attached to constructive ownership rules and attribution of ownership when calculating ownership interests that comply with the ten percent rules.

The effect of these provisions can be combined. Only those shareholders who own ten percent or more of foreign corporation stock are deemed to be United States shareholders when a calculation is made to ascertain whether a foreign corporation is owned or the value of the stock owned exceeds fifty percent. This is the criterion to establish whether a foreign corporation has an ownership structure that subjects it to the imposition of Subpart F Income rules.

Foreign corporation shareholders who are United States persons, but own less than a ten percent interest of the foreign corporation stock value, are deemed not to be United States shareholders of a foreign corporation. Therefore, for purposes of determining whether a shareholder is subject to Subpart F Income treatment, a United States person owning less than a ten percent interest of a foreign corporation is not a component in the ownership computation for purposes of determining control status. (9)

Ownership and Attribution Rules

In making calculations of foreign corporation stock ownership, the significance of the ownership attribution rules are a complexity and an unavoidable part of ownership structural planning. The indirect and constructive ownership rules, whose primary purpose is to constructively attribute Subpart F Income to a United States shareholder, provide a limited form of stock attribution (10)

Generally, ownership is constructively attributed to a United States person for several purposes. It is attributed in order to treat a United States shareholder as a related person for purposes of the calculation of ownership attribution, to treat the stock of a domestic corporation as owned by a United States shareholder of a foreign corporation, or to treat a foreign corporation as a controlled foreign corporation. (11) An individual is generally considered as being the owner of stock owned directly or indirectly by or for his spouse, his children, grandchildren and parents. (12) Stock deemed to be constructively owned by virtue of the ownership rules is to be treated actually owned by such a person. (13) If a person’s proportionate interest in a foreign corporation is being calculated, it generally is determinative with reference to the income interest of the person in the corporation. (14)

If calculating the amount of voting power owned with reference to the constructive rules, a person’s proportionate interest in a foreign corporation is generally determined by reference to the amount of voting power. (15) These attribution rules can be applied in the following manner. In the structure of ownership whereby a partnership, estate, trust, or corporation owns directly or indirectly more than fifty percent of the total combined voting power of all classes of stock of a corporation, it shall be considered as owning all the stock. (16)

The attribution rules create a chain of ownership. However, because ownership is attributed only to stock owned by a foreign entity, attribution under the rule stops with the first United States person in the chain of ownership running from the foreign entity. (17) In the determination of a person’s proportionate interest in a foreign corporation, foreign partnership, foreign trust, or foreign estate, all the facts and circumstances of each case will be the basis for that conclusion. (18)

The basic exception to stock being attributed to another shareholder occurs when a nonresident alien individual owns stock, excluding nonresident by virtue of being a foreign trust or estate. In such case, the stock shall not be considered as owned by a United States citizen or a resident alien individual. This exception does not apply when the constructive rules are applied in determining whether the stock of a domestic corporation is owned or considered owned by a United States shareholder. (19)

Ownership is generally attributable to ownership from partnerships, estates, trusts and corporations. (20) However, important distinctions are made with respect to corporations and trusts. As to corporations, if ten percent or more in value of stock in a corporation is owned, directly or indirectly, by or for any person, that person is considered as owning the stock. (21) If less than ten percent is owned, that attribution of ownership would not be applicable. With respect to trusts, stock owned directly or indirectly by or for a beneficiary of a trust shall be considered as owned by the trust unless the beneficiary’s interest in the trust is a remote contingent interest. A contingent interest of a beneficiary in a trust shall be considered remote if, under the maximum exercise of discretion by the trustee in favor of such beneficiary, the value of such interest computed actuarially is five percent or less of the value of the trust property. (22)

The constructive ownership rules define whether a foreign corporation is controlled and whether a United States person is a United States shareholder. These are the two important conclusions in corporate organizational structural planning. They are a type of statutory provision that lend themselves to hypothetical examples to confirm interpretation of the provisions.

Distinguishing Subpart F Income Structures

In light of this, the following corporate hypothetical structures are set forth to illustrate possible structures that can be used in organizational planning.

Hypothetical 1

 

 

 

 

 

 

 

 

 

 

 

It is assumed in this example that all the United States shareholders are not related. In this structure, the corporate entity would not be a controlled foreign corporation because there are no United States shareholders for taxation purposes. This is the result because the United States shareholders own not more than 10 percent of the value or voting power. (23)

Hypothetical 2

 

 

 

 

 

 

 

 

 

 

 

 

It is assumed in this example that all the United States shareholders are not related. In this structure, the corporate entity would not be a controlled foreign corporation because there are no United States shareholders for taxation purposes. This result occurs because United States shareholders own not more than 10 percent of the value or voting power. (24)

Hypothetical 3

 

 

 

 

 

 

 

It is assumed in this example that all the United States shareholders are not related. In this structure, the corporate entity would not be a controlled foreign corporation because United States shareholders for purposes of taxation own not more than fifty percent of the value or voting power. (25)

Hypothetical 4

 

 

 

 

 

 

 

 

It is assumed in this example that all the United States shareholders are not related. In this structure, the corporate entity would be regarded as a controlled foreign corporation because United States shareholders for purposes of taxation own more than fifty percent of the value. (26)

Hypothetical 5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

It is assumed in this example that all United States shareholders are unrelated. In this structure the corporate entity is not a controlled foreign corporation because it does not have any United States shareholders for purposes of taxation. (27)

Hypothetical 6

 

 

 

 

 

 

 

 

 

It is assumed in this example that all United States shareholders are unrelated. In this structure the corporate entity is not a controlled foreign corporation because United States shareholders own not more than fifty percent of the voting power of value. (28)

Hypothetical 7

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

It is assumed in this example that all United States shareholders are unrelated and the fair market value of each voting and non-voting share is $1.00. In this corporate structure, the entity is a controlled foreign corporation because United States shareholders for purposes of taxation own more than fifty percent of the value. (29)

 

Hypothetical 8

 

 

 

 

 

 

 

 

It is assumed in this example that all United States shareholders are unrelated. In this corporate structure, the entity is a controlled foreign corporation because United States shareholders own more than fifty percent of the total combined voting power. (30)

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Footnotes

 

1. IRC Section 957(a) (1986).

2. IRC Section 951 (b) (1986).

3. IRC Section 952 (a) (1986).

4. RC Section 957 (a) (1986). Prior to the Tax Reform Act of 1986, this determination of what foreign corporations were deemed to be controlled was made by defining control as owning more than fifty percent of the combined voting power of all classes of voting stock of the foreign corporation. The value criteria has been added to deflect continued attempts of taxpayers to artificially shift formal voting power from United States shareholders of foreign corporations to elude “control” status. See, Garlock, Inc. 58 TC 423 (1972) and Hans P. Krause, 59 TC 423 (1973). These cases will continue to offer guidelines because as will be seen in subsequent text, the value criteria was not incorporated in other inter-dependent sections of Subpart F and remain fertile for planning opportunities.

5. IRC Section 958 (1986).

6. IRC Section 951 (b) (1986). A United States person for purposes of this code section is defined in accordance with IRC Section 957 (c) (1986) which is basically a similar definition ascribed by IRC Section 7701 (a) (30) (1986). Constructive ownership rules are governed by IRC Section 958 (1986) for purposes of IRC Section 951 (b) (1986).

7. IRC Section 7701 (a) (30) (1986).

8. IRC Section 951 (b) (1986).

9. IRC Section 957 (1986).

10. Treas. Reg. Section 1.958 – 1(a) of the IRC of 1986 and as thereafter amended.

11. Treas. Reg. Section 1.958 – 1(b) of the IRC of 1986 and as thereafter amended.

12. Treas. Reg. Section 1.958 – 2 (b) of the IRC of 1986 and as thereafter amended.

13. Treas. Reg. Section 1.958 – 1 (b) of the IRC of 1986 and as thereafter amended.

14. Treas. Reg. Section 1.958 – 1 (b) (2) of the IRC of 1986 and as thereafter amended.

15. Id. at note 14.

16. Treas. Reg. Section 1.958 – 2 (c) (2) of the IRC of 1986 as thereafter amended.

17. Treas. Reg. Section 1.958 -1 (b) of the IRC of 1986. The following is an illustration set forth in Treasury Regulations to demonstrate the “stopping rule”. Domestic corporation M owns seventy-five percent of the one class of stock in a foreign corporation R, which in turn owns eighty percent of the one class of stock in foreign corporation S, which in turn owns ninety percent of the one class of stock in foreign corporation T. Under this paragraph, R corporation is considered as owning eighty percent of the ninety percent of the stock which S corporation owns in T corporation, or seventy-two percent. Corporation M is considered as owning seventy-five percent of such seventy-two percent of the stock in T corporation, or fifty-four percent. Since M corporation is a domestic corporation, the attribution under this paragraph stops with M corporation, even though such corporation is wholly owned by domestic corporation N.

18. Treas. Reg. Section 1.958 – 1 (c) (2) of the IRC of 1986 and as thereafter amended.

19. Treas. Reg. Section 1.958 – 2 (b) (3) of the IRC of 1986 and as thereafter amended.

20. Treas. Reg. Section 1.958 – 2 (c) (1) (i), (ii), and (iii) of the IRC of 1986 and as thereafter amended.

21. Treas. Reg. Section 1.958 – 2 (c) (iii) of the IRC of 1986 and as thereafter amended.

22. Treas. Reg. Section 1.958 – 2 (d) (ii) (a) of the IRC of 1986 and as thereafter amended.

 

23. Glen A. Stankee, Esquire, Ruden, Barnett, McClosky, Smith, Scuster & Russel, P.A., Ft. Lauderdale, Planning Around and Within Subpart F, The Florida Bar Continuing Legal Education Committee, The Tax Section and The Florida Institute of Certified Public Accountants, January 19-20, 1995.

24. Id. at 23.

25. Supra, note 23.

26. Supra, note 23.

27. Supra, note 23.

28. Supra, note 23.

29. Supra, note 23

30. Supra, note 23