In our last thrilling episode
of The Form 5471 Files, we considered the curious case of a U.S. manufacturer that sold widgets to its lower-tier foreign subsidiary, which turned around and sold the widgets to an unrelated U.S. customer.
The result, we decided, is that Foreign Subsidiary’s profit was foreign base company sales income
, which is Subpart F income.
But whose income is it?
We know that “United States shareholders” take a controlled foreign corporation’s Subpart F income into their gross income. But . . .
- There are three United States shareholders of 100% of Foreign Subsidiary’s stock. Why?
- Which one of them gets the $50 of Subpart F income?
Then we’re going to ask the Elmo Question.
- Why would the taxpayer deliberately create $50 of Subpart F income?
Why wouldn’t a U.S. manufacturer sell a product directly to a U.S. customer? (That sale is shown with the dotted line in the diagram below).
In either case, there will be $70 of gross income subject to Federal income tax. Why be complicated when you can be simple?
Foreshadowing the discussion below:
- Who is a United States shareholder? Domestic HoldCo, ManufacturerCo, and U.S. citizen are all United States shareholders of Foreign Subsidiary and are considered to own 100% of its stock.
- Who gets the Subpart F income? Domestic HoldCo.
- Why create Subpart F income? Maybe Domestic HoldCo had some attractive tax attributes (e.g., an NOL), or could efficiently use the indirect foreign tax credit for corporate income tax paid by Foreign Subsidiary (IRC §960). If not, a domestic C corporation could absorb $50 gross income at a lower effective tax rate (21%) than the U.S. individual shareholder of the S corporation (37%).
Three United States Shareholders
“Everybody knows” (hah) that a CFC’s Subpart F income gets allocated to its United States shareholders. IRC §951(a).
We have three United States shareholders in this structure. Let’s see why.
Definition: United States Shareholder
A taxpayer is a “United States shareholder” of a foreign corporation when two things are true:
- Status as a “United States person” and
- Ownership of enough stock (10% or more) in the right way (as ownership is defined in IRC §958(a) or (b)).
United States shareholder is defined in IRC §951(b):
IRC §951(b) United States shareholder defined. For purposes of this title, the term “United States shareholder” means, with respect to any foreign corporation, a United States person (as defined in section 957(c)) who owns (within the meaning of section 958(a)), or is considered as owning by applying the rules of ownership of section 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation.
Definition: United States Person
There is already a perfectly good definition of “United States person” in IRC §7701(a)(30) but for controlled foreign corporation purposes the Code adds some special exceptions and modifications for taxpayers from U.S. possessions and territories. The exceptions and modifications are unimportant for this newsletter, so the rule we apply is the bog-standard rule from IRC §7701(a)(30).
IRC §957(c) United States person. For purposes of this subpart, the term “United States person” has the meaning assigned to it by section 7701(a)(30) except that [convoluted stuff that only applies to taxpayers from U.S. possessions and territories].
You might guess that our U.S. citizen and two Delaware corporations are “United States persons.” You are right. Let’s not chase the rabbit.
Now all we need to prove is that the three taxpayers own “enough” stock of Foreign Subsidiary (10% or more) in the “right way” (as defined in IRC §958(a) or IRC §958(b)).
Domestic HoldCo: United States Shareholder
Domestic HoldCo is a United States shareholder of Foreign Subsidiary.
Domestic HoldCo is a United States person and owns 100% of the stock of Foreign Corporation directly because of IRC §958(a)(1)(A).
IRC §958(a) Direct and indirect ownership
(1) General rule. For purposes of this subpart (other than section 960), stock owned means—
(A) stock owned directly[.]
This makes Domestic HoldCo a United States shareholder as defined by IRC §951(b).
ManufacturerCo: United States Shareholder
ManufacturerCo is also a United States shareholder. It is a United States person, and is treated as owning 100% of the stock of Foreign Subsidiary by application of the attribution rules in IRC §958(b).
(Remember that the IRC §951(b) definition of “United States shareholder” requires “enough” stock to be owned using the definitions of ownership in either IRC §958(a) or IRC §958(b)).
ManufacturerCo is a constructive shareholder of Foreign Subsidiary as defined in IRC §958(b), which requires application of the IRC §318(a) constructive ownership rules.
IRC §318(a)(2)(C) is the rule that matters:
If 10 percent [IRC §958(b)(3) modifies the original 50% number in IRC §318(a)(2)(C)] or more in value of the stock in a corporation is owned, directly or indirectly, by or for any person, such person shall be considered as owning the stock owned, directly or indirectly, by or for such corporation, in that proportion which the value of the stock which such person so owns bears to the value of all the stock in such corporation.
Applying this constructive ownership rule:
- Fact. ManufacturerCo owns 100% of the stock of Domestic HoldCo.
- Analysis. Therefore, ManufacturerCo is treated as owning all of the stock owned by Domestic HoldCo. IRC §§318(a)(2)(C), 958(b).
- Fact. Domestic HoldCo owns 100% of the stock of Foreign Subsidiary.
- Conclusion. Therefore, ManufacturerCo is treated as the constructive owner of 100% of the stock of Foreign Subsidiary.
Because ManufacturerCo is a United States person and owns 10% or more of Foreign Subsidiary stock by application of IRC §958(b), it is a United States shareholder of Foreign Subsidiary.
U.S. Citizen: United States Shareholder
What about U.S. citizen, who is the 100% shareholder of ManufacturerCo? He is a United States shareholder as that term is defined in IRC §951(b).
Recall that a United States person must own 10% or more of the stock of a foreign corporation by applying either IRC §958(a) or IRC §958(b).
For U.S. citizen, IRC §958(b) does the trick. It invokes the basic rules of IRC §318(a), and IRC §318(a) treats U.S. citizen as a 100% shareholder of Foreign Subsidiary.
Let’s look at the specific attribution logic under IRC §318(a) that will allow us to attribute 100% of the stock ownership of Foreign Subsidiary SA to U.S. citizen and make him be a United States shareholder of Foreign Subsidiary SA.
The way we do that is by creating a chain of ownership from DomesticHoldCo to ManufacturerCo to U.S. citizen, and conclude that U.S. citizen “owns” Foreign Subsidiary stock by application of IRC §958(b).
- Fact. Domestic HoldCo is the direct shareholder of Foreign Subsidiary shares.
- Analysis. ManufacturerCo is the 100% shareholder of Domestic HoldCo. As such, ManufacturerCo is treated as the constructive owner of all of the corporate stock that Domestic HoldCo owns. IRC §318(a)(2)(C).
- Conclusion. ManufacturerCo is therefore the constructive owner of Domestic HoldCo’s 100% stock ownership of Foreign Subsidiary stock.
Now we show that ManufacturerCo’s “constructive” ownership of Foreign Subsidiary stock is the same as “actual” ownership.
- Fact. ManufacturerCo is the constructive owner of 100% of Foreign Subsidiary stock.
- Analysis. ManufacturerCo, a constructive owner of Foreign Subsidiary stock, is treated as the “actual” owner of Foreign Subsidiary stock. IRC §318(a)(5)(A).
- Conclusion. Therefore, ManufacturerCo is the actual owner of Foreign Subsidiary stock.
Finally, we show that ManufacturerCo’s “actual” ownership of Foreign Subsidiary stock means that U.S. citizen is a constructive owner of that stock because of IRC §958(b), making him a United States shareholder.
- Fact. Start with ManufacturerCo as the actual owner of 100% of Foreign Subsidiary stock.
- Analysis. U.S. citizen owns 100% of ManufacturerCo stock. As such, U.S. citizen is treated as the constructive owner of all of the corporate stock that ManufacturerCo owns. IRC §318(a)(2)(C).
- Conclusion. Therefore, U.S. citizen is the constructive owner of the Foreign Subsidiary stock “actually” owned by ManufacturerCo. IRC §958(b).
Domestic HoldCo Gets the Subpart F Income
Bottom line up front: Domestic HoldCo includes the Subpart F income in its gross income, and it does so because it is treated as owning the Foreign Subsidiary stock in the “right” way: because of stock ownership as defined by IRC §958(a).
IRC §951(a)(1)(A) says which United States shareholder takes the Subpart F income into gross income. The key phrase is emphasized:
IRC §951(a) Amounts included.
(1) In general. If a foreign corporation is a controlled foreign corporation at any time during any taxable year, every person who is a United States shareholder . . . of such corporation and who owns (within the meaning of section 958(a)) stock in such corporation on the last day, in such year, on which such corporation is a controlled foreign corporation shall include in his gross income, for his taxable year in which or with which such taxable year of the corporation ends—
(A) his pro rata share (determined under paragraph (2)) of the corporation’s subpart F income for such year[.]
Domestic HoldCo owns 100% of the Foreign Subsidiary shares directly, therefore ownership is established by application of IRC §958(a)(1)(A). DomesticHoldCo will take Foreign Subsidiary’s $50 of Subpart F income into its gross income.
ManufacturerCo and U.S. citizen own 100% of Foreign Subsidiary shares constructively, through application of IRC §958(b). Therefore, the inclusion rule of IRC §951(a)(1)(A) will not apply to them and they will not take any of the Subpart F income into their gross income.
Finally . . . Why?
Let’s step back and look at the big picture. Why gratuitously create Subpart F income if it is easy to avoid? This hypothetical example is derived from a real question I received from a real accountant about a real income tax return he prepared. I don’t know any of the facts in real life. But here are some guesses.
$70 of Profit Taxable Either Way
Look at the two ways to create a transaction here. Both methods create $70 of gross income that will be subject to income tax in the year of the transaction.
If ManufacturerCo sold the widget to the U.S. customer, it would have $70 of gross income, and because it is an S corporation, the individual shareholder would report $70 of gross income and pay income tax.
Instead, ManufacturerCo sold the widget to Foreign Subsidiary, created $20 of gross income, and passed that through to the individual shareholder. The other $50 of income on this transaction is Subpart F income and is taxable to Domestic HoldCo, as demonstrated above.
Note that my guesses are highly fact-specific, and we will never know the Truth. I give you these guesses just so you might have a spark of creativity someday.
- Domestic HoldCo could have a net operating loss that would offset the $50 of Subpart F income. The NOL would go unused if ManufacturerCo received the $50 of gross profit.
- The indirect foreign tax credit rules of IRC §960 allow a C corporation shareholder of a controlled foreign corporation to claim a foreign tax credit for foreign corporate income tax paid by the CFC. Maybe a foreign tax credit could eliminate Domestic HoldCo’s Federal corporate income tax.
- There might be some weird tax or politically-motivated (therefore economically beneficial to the company) social engineering law in the foreign country designed to encourage transactions like this.
- Maybe the business wants to retain cash for future expansion. The $50 of Subpart F income received by Domestic HoldCo will be taxed at 21%. The same $50 of income, if received by the S corporation, would be taxed at the individual shareholder level at 37%. More cash is left over if the $50 of gross income is taxed in the C corporation.
There are probably other ideas we could come up with.
In this post I gave you a glimpse into:
- How to determine whether a taxpayer is a United States shareholder.
- You can (and probably will) have more than one United States shareholder for the same shares of foreign corporation stock.
- How to determine who among multiple United States shareholders, will include the CFC’s Subpart F income in gross income.
- And we speculated about why you might want to deliberately invoke the Subpart F rules to point the firehose of taxable income in one direction or another for tax saving reasons.