Florida Tax Attorney Blog

Under Subpart F of the Internal Revenue Code, U.S. shareholders of a controlled foreign corporation ("CFC") must include the CFC's "subpart F income" on their U.S. income tax returns. I.R.C. § 951. For a foreign corporation to be classified as a CFC for tax purposes, it must be controlled by U.S. shareholders. Significantly, the terms "control" and "U.S. shareholder" are specifically defined legal terms. In this respect, "control" means more than 50% of the vote and value of the corporation and a "U.S. shareholder" means a shareholder who holds 10% or more of the total voting power. Thus, a foreign corporation is considered a CFC if 10% shareholders collectively own more than 50% of the corporation.

But how is "U.S. shareholder" status determined when a U.S. partnership owns a foreign corporation? For instance, consider the scenario where a U.S. general partnership owns 100% of a foreign corporation that generates subpart F income. Assume that none of the individual partners hold a greater than 5% partnership interest. Since none of the individual partners hold a greater than 5% partnership interest, none of them can constructively be considered "U.S. shareholders" by application of upward entity attribution (because 10% ownership is required). Therefore, the foreign corporation cannot be considered a CFC, and none of the individual partners will be required to recognize subpart F income, right? Wrong. A U.S. partnership is considered a "U.S. person" for tax purposes. I.R.C. § 7701(a)(30). Moreover, nothing in Subpart F or the regulations thereunder indicates that a domestic partnership cannot be a "U.S. shareholder" for Subpart F purposes. Consequently, the U.S. partnership would be considered to be a U.S. shareholder because it satisfies the 10% or more ownership test. Moreover, since the U.S. partnership owns more than 50% of the foreign corporation, the foreign corporation would be considered a CFC. As a result, the partnership will have Subpart F income, and because a partnership is a pass-through entity, this Subpart F income will pass-through to the individual partners, notwithstanding the fact that none of them are "U.S. shareholders" within the definition of that term.

Takeaway: Partners of a U.S. partnership with an interest in a foreign corporation may have Subpart F income to report.

Partnerships and LLCs taxed as partnerships are pass-through entities in the sense that all of the income and expense items pass through the entity to the individual partners and are reported on the partners' individual tax returns. In order to prevent abuse, the tax code places several limits on the deductibility of partnership losses. One such limit is the "at risk" principle found in Section 465 of the Internal Revenue Code. Pursuant to that statute, a partner (or LLC member in an LLC taxed as a partnership) may deduct partnership losses only to the extent that he or she is "at risk." In other words, partnership losses are deductible only to the extent of the partner's financial risk exposure (i.e. how much money the partner stands to lose). Of course, a partner is "at risk" to the extent of cash contributions that have been made to the partnership. I.R.C. § 465(b)(1). However, a partner is not considered at risk for required future capital contributions unless and until the partner actually contributes the funds. Prop. Treas. Reg. § 1.465-22(d).

At the same time, however, a partner's amount at risk includes borrowed amounts to the extent that the partner is personally liable for repayment of a partnership debt. I.R.C. § 465(b)(2); Prop. Treas. Reg. § 1.465-24(a). In this respect, a partner is "personally liable" for at-risk purposes if he has ultimate liability to repay the partnership debt obligation. In other words, we are looking for the person upon whom the liability will eventually fall upon as a practical matter. At a high level then, the determination as to whether a partner is "at risk" with respect to a partnership or LLC debt appears to be a specific application of economic substance principles. Since economic reality controls the at-risk analysis, logic would dictate that a partner should be entitled to an increased at-risk amount to the extent that a deferred or future contribution obligation makes the partner potentially liable for a partnership debt, notwithstanding the rule articulated in Prop. Treas. Reg. § 1.465-22(d). This result is arguably supported by judicial authority.

In Hubert v. Commissioner, the Sixth Circuit effectively held that a partner's contribution obligation can support an increased at-risk amount to the extent that it operates in a way that causes the partner to become liable for a portion of the partnership's debts. Similarly, the Tax Court has held a partner to be at risk with respect to a deferred contribution obligation where the partnership pledged its right to receive that future contribution to an unrelated institutional lender as collateral for a bank loan. See Melvin v. Commissioner. The Tax Court reasoned that the deferred capital contributions would ultimately serve as the source of repayment in the event of the partnership's default on the loan.

In light of the foregoing, a partner may be at risk with respect to future contribution obligations. This increased at-risk amount would allow the partner to deduct a greater portion of his distributive share of a partnership loss. Note, however, that the circumstances under which a future contribution obligation is sufficient to support at-risk basis are very specific.

If you need help calculating your at-risk amount or structuring a partnership loan transaction to support an increased at-risk amount, contact me today.

The Supreme Court is set to review the Defense of Marriage Act ("DOMA") soon. In my opinion, DOMA violates at least three separate provisions of the U.S. Constitution. Most obviously, DOMA clearly violates the explicit guarantee of equality contained in the Equal Protection Clause. In addition, DOMA violates the Due Process Clause insofar as it deprives a significant minority of Americans of the constitutional right of marriage. Finally, DOMA arguably violates the First Amendment's guarantees of religious freedom insofar as primary opposition to same-sex marriage appears to be religiously based. In light of the foregoing, I expect the Supreme Court to invalidate DOMA. From a tax perspective, the invalidation of DOMA will trigger a right to tax refunds for prior year overpayments (because same-sex married couples have been denied the favorable tax treatment associated with being married). From a tax planning perspective, same-sex couples who may be entitled to a tax benefit should not wait for a final decision from the Supreme Court before filing a protective refund claim with the Internal Revenue Service. Rather, same-sex couples who are legally married should file claims now in order to protect their refund rights from expiring under the three-year statute of limitations that applies with respect to tax refund claims.

The U.S. Supreme Court has agreed to consider whether a domestic taxpayer is entitled to a foreign tax credit based on its payment of a windfall tax to the U.K. government. The Court's decision to grant certiorari in PPL Corp is expected to resolve a split among the circuit courts of appeal.

Facts

Beginning in the mid-1980s, the U.K. privatized several utility companies by selling shares in the public market. Following privatization, costs were reduced, and these utility companies became enormously profitable as a result. The shareholders who initially purchased stock of the utility companies were therefore able to sell the shares at enormous profits. Upon seeing this, the U.K. government effectively concluded that the utility companies were privatized at too low of a price (i.e. the government did not get enough money for the shares). Accordingly, the government decided to impose a windfall profits tax. The windfall tax was a one-time 23 percent tax on the difference between each company's profit-making value and the price for which the U.K. government had sold it. Many U.S. taxpayers had acquired shares in these utility companies. Consequently, the question quickly became whether the windfall profits tax was a creditable tax for foreign tax credit purposes.

Procedural History

The taxpayer involved in PPL filed a refund claim seeking a foreign tax credit for windfall profits tax paid to the U.K. The IRS disallowed the refund and the taxpayer petitioned the Tax Court.

The Tax Court initially held that the taxpayer was entitled to a foreign tax credit on the ground that the tax was on profits making it essentially in the nature of an income tax. However, the IRS appealed, and the Third Circuit Court of Appeals concluded that the windfall profits tax was not a creditable foreign tax and reversed the Tax Court. Significantly, however, the Fifth Circuit Court of Appeals agreed with the Tax Court in a companion case (Entergy Corp.).

Certiorari Granted

As previously mentioned, the Third Circuit and the Fifth Circuit reached opposite conclusions regarding the deductibility of the U.K. windfall profits tax. The Supreme Court opinion will resolve this judicial split between the Third and Fifth Circuits. Hopefully it will also provide some insight for future analysis of foreign tax credit issues. However, the U.K. windfall profits tax is very unique and therefore the opinion will likely be narrow and specific to the nature and characteristics of the U.K. windfall profits tax. With that being said, I would not expect on too much insight beyond what we already have in terms of foreign tax credit analysis as a practical matter.

The Digital Goods and Services Tax Fairness Act (H.R. 1860) was introduced May 12, 2011 and would prohibit state and local governments from imposing taxes on certain sales of digital goods and services that are taxable under current law. The stated intention of H.R. 1860 is to promote neutrality, simplicity, and fairness in the taxation of electronic goods and services. But good intentions are not enough.

As a threshold matter, the proposed legislation arguably exceeds Congress' enumerated powers.

Commerce Clause. The Supreme Court has substantially narrowed its interpretation of the scope of the commerce power in recent years. In this regard, the Court has emphasized the importance of distinguishing between national matters and matters that are truly local. State and local taxation is a local matter insofar as revenue needs and tax issues vary among jurisdictions. The states are in the better position to identify issues with their tax systems and implement remedial measures.

14th Amendment. State action is a necessary prerequisite to the exercise of Congress' Section 5 power. It does not appear that Congress has made any factual findings of actual incidences of discriminatory taxation. To be sure, preventative rules are sometimes necessary, but even then, they must be appropriately tailored to reach the perceived threat in order to pass constitutional muster. The restrictions imposed on states' taxing rights by this legislation are too great in comparison to the threat of discriminatory taxation.

Even if Congress has authority to enact this legislation, the focus on tangible versus intangible is misplaced. A sales tax is best summarized as a tax on consumption. In this respect, there are two basic precepts to the sales tax: (1) all personal consumption should be taxed; and (2) all business inputs should be exempt. Yet, the inquiry as to whether the thing being conveyed is tangible or intangible says nothing about personal consumption or business inputs. Not only does this legislation focus on the wrong issue, but it also explicitly contravenes the established principle that business inputs should not be taxed. See Sec. 5(2)(B) (specifying business location as tax address for sourcing purposes when item is delivered to a business); Sec. 5(2)(F) (indicating that advertising services are sales taxable).

Moreover, although the proposed legislation apparently seeks to "promote neutrality, simplicity, and fairness in the taxation of digital goods and services," it will actually do the opposite. A "digital good" includes a variety of downloadable content - e.g., software, music albums, films, e-books, photography. Significantly, the downloaded content is no different than the content acquired through off-the-shelf software, CDs, DVDs, traditional books, or traditional photos. Yet, these items would be subject to a special federal tax regime under the proposed legislation. Such disparity is not neutral, simple, or fair. The substance of the transaction rather than the form of delivery should govern tax consequences. In this respect, the focus should be on consumption.

To be sure, risks of multiple taxation remain even when the focus is on consumption. However, States are competent to deal with these issues, and the drafters of this bill would agree according to Section 8 (expressing States' competency to deal with multiple taxation in international context). In the e-commerce environment, the issues of multiple taxation are similar domestically and internationally. So if Congress has faith in the States' ability to handle the issue on an international level, then the States are certainly competent to handle the issue domestically.