Florida Tax Attorney Blog

Beginning in 2012, taxpayers classified as Category 5 filers who constructively own stock of a controlled foreign corporation ("CFC") will be eligible for the constructive ownership exception from filing IRS Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, with their U.S. tax returns. Previously, the constructive ownership exception from 5471 filing was only available to Category 3 and Category 4 filers.

What is IRS Form 5471?

Form 5471 is used by certain U.S. citizens and residents who are officers, directors, or shareholders in controlled foreign corporations (as that term is defined by the Internal Revenue Code). This form must be included with the U.S. tax return to satisfy certain reporting requirements set forth in the Internal Revenue Code.

Categories of Filers

The IRS has set forth several categories of filers. Generally, any U.S. person that falls within one of these categories must file Form 5471 with the IRS. A Category 5 filer includes a U.S. shareholder who: (1) owns stock in controlled foreign corporation for an uninterrupted period of 30 days or more during the foreign corporation's tax year; and (2) owned that stock on the last day of the foreign corporation's tax year. In this respect, a Category 5 filer's stock ownership can be direct, indirect, or constructive.

Prior to 2012, Category 5 filers who indirectly owned stock of a CFC were required to file Form 5471 with their U.S. tax returns, notwithstanding the fact that they did not actually own any stock of the CFC. However, going forward, Category 5 filers who do not directly own stock of a CFC may be exempt from filing Form 5471 under the constructive ownership exception. This change comes via revised form instructions for Form 5471 published by the IRS on January 18, 2013. The extension of the constructive ownership exception to Category 5 filers should reduce compliance burdens for many taxpayers and should reduce administrative burdens for the IRS.

To qualify for the exception, a Category 3, 4, or 5 filer must satisfy each of the following requirements:

(1) the U.S. person must have no ownership of a direct interest in the foreign corporation;

(2) the U.S. person must be required to furnish the information requested solely because of constructive ownership through another U.S. person; and

(3) the U.S. person through whom the indirect shareholder constructively owns an interest in the foreign corporation must file Form 5471 to report all of the required information.

As a final matter, it should be noted that Category 5 taxpayers who qualify for the constructive ownership exemption from filing Form 5471 going forward should also be exempted from filing IRS Form 8858 for foreign disregarded entities (FDEs) owned by the CFC because the constructive ownership exception exempts such taxpayers from filing Form 8858.

According to a circular released by the Chinese Ministry of Science and Technology on January 11, 2013, Chinese tax authorities have begun a large scale audit of technology companies that claim a special tax status as High and New Technology Enterprises ("HNTEs"). See Circular Guokefahuo No. 1220. Currently, companies that qualify as HNTEs pay a corporate income tax rate of 15%, which is ten percentage points less than the standard Chinese corporate tax rate of 25%.

In terms of qualifying for this special tax status, both Chinese and non-Chinese companies doing high-tech work in areas such as electronics, information technology, biotech and new medical technologies, energy conservation, environmental technology, aerospace, and high-tech transformation of traditional industries are potentially eligible for the HNTE tax break. Companies that fail to qualify as HNTEs under this audit will have their HNTE status revoked and will consequently experience a tax rate increase of 10%. In addition to current year tax increases, these companies may be liable for back taxes, fines, and penalties.

Most likely, this large scale audit is being driven by non-tax fiscal and political factors - namely, the growth rate of China's economy has begun to slow down; as a result, Chinese tax authorities are likely feeling pressured to collect adequate revenues. A crackdown on the HNTE tax break is a potential revenue source because, as of December 31, 2012, more than 60,000 technology companies had claimed this special tax status for Chinese tax purposes, possibly amounting to as much as $USD 32 billion in tax breaks.

Given the large scale of this audit by Chinese tax authorities, companies that claim HNTE status (or have claimed HNTE status in the past) should contact a tax firm to ensure that they satisfy all HNTE eligibility requirements. This self-audit of sorts should be done as soon as possible so that any necessary remedial or protective action can be promptly implemented. Note that even companies that satisfy the criteria for HNTE status often make mistakes that could cause Chinese tax authorities to question their HNTE status during this large-scale audit. Consequently, any company claiming this tax benefit for Chinese tax purposes would be well-advised to engage a tax firm to analyze their eligibility for HNTE status.

For federal tax purposes, a foreign-based company must have a U.S. "permanent establishment" in order to be subject to federal taxation. In this respect, the concept of a U.S. permanent establishment essentially means a fixed place of business in the United States. Significantly, however, the permanent establishment concept, which drives federal taxation of foreign-based businesses, is generally irrelevant in the state tax context.

For state tax purposes, an in-state presence does not have to be fixed or permanent. To the contrary, the requisite level of presence for state taxing jurisdiction can be created by the transitory presence of an employee, non-employee representatives, or even non-physical presence. In other words, the level of contact required to establish state taxing nexus is substantially less than the level of contact required to establish federal taxing nexus. As a result, the absence of a permanent establishment for federal tax purposes does not necessarily mean that a foreign-based company is not subject to state taxation in the United States.

It is important for foreign-based companies to be aware of this for several reasons. From a compliance perspective, the compliance costs can be substantial even if the state tax liability itself is nominal - i.e. bookkeeping, tax calculation, return preparation. In addition, from a liability perspective, many state laws, including Florida, often allow for collection of unpaid state taxes from individuals associated with a business who should have been aware of the business's state tax obligations and of the business's failure to comply with those obligations - e.g., partners, officers, managers.

Under the general provisions of I.R.C. § 332, no gain or loss is recognized by a parent company upon liquidation of an 80% or more owned subsidiary. However, this result may be changed when a foreign subsidiary is the subject of the liquidation.

To the extent that the foreign subsidiary has accumulated earnings and profits ("E&P") from active foreign business operations, that E&P will be subject to U.S. taxation at the domestic parent company level upon liquidation. This is because these earnings and profits were generated by non-subpart F income that was not "effectively connected" with an active U.S. trade or business. Therefore, these earnings and profits have never been subjected to U.S. taxation. If these earnings and profits were allowed to travel up to the domestic parent company tax-free under Section 332, then untaxed E&P would effectively become available for distribution to the domestic parent company's shareholders.

The way the Internal Revenue Code deals with this is to impose a toll charge of sorts upon repatriation of the foreign subsidiary's assets into the United States. More specifically, the U.S. parent company must include a deemed dividend in income based on something called the "all E&P amount." The "all E&P amount" is basically the untaxed E&P that has accumulated in the foreign subsidiary under the parent company's period of ownership. As a final note, it is worth mentioning that there may be foreign tax credit implications as a result of this inclusion. In this respect, the deemed dividend included by the U.S. parent would be a foreign source dividend. This foreign source dividend, in turn, may carry with it a portion of foreign taxes paid with respect to that E&P and the related foreign tax credits.

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.

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.

Private equity funds are typically organized as limited partnerships ("LP") in order to obtain both limited legal liability and the tax benefits associated with the flow-through entity structure. In this respect, the limited partnership is often organized in a favorable foreign tax jurisdiction (e.g., the Caymans) rather than in the United States. In addition, private equity funds are making more and more foreign investments, which often involves the acquisition of foreign companies. But although private equity funds are often organized abroad and investing abroad, they continue to be managed out of the United States.

This raises a significant tax question: If a foreign corporation is owned 100% by a foreign limited partnership which is managed by a U.S. general partner does the U.S. general partner taint the corporation so that it constitutes a controlled foreign corporation ("CFC") for tax purposes?

The concern with the U.S. general partner is that the general partner is effectively in control of the foreign corporation by virtue of its status as general partner of the private equity fund. In many ways, a general partner can be analogized to a board of directors. And given this element of control, the foreign corporation would likely be treated as a CFC for tax purposes absent certain unique terms in the limited partnership agreement. As a result, the investors become subject to Subpart F of the Internal Revenue Code. The specific tax implications of Subpart F are beyond the scope of this article, but they may be adverse. This is not to say that a private equity fund should never be structured as described above. And indeed, this structure may be unavoidable in some contexts giving the increasingly globalized investment climate. What's important is that management be aware of the potential tax implications in order to ensure compliance and avoid IRS penalties.

If you would like assistance evaluating the international tax consequences of a potential or existing private equity fund, feel free to contact me via phone or email. Initial consultations are always free!

Private equity funds typically seek to attract three types of investors:

(1) U.S. Investors - both individual and corporate, but mostly corporate
(2) U.S. Tax-Exempt Investors - e.g., pension funds
(3) Foreign Investors

Critical to the investment decision for tax-exempt and foreign investors is that the private equity fund not be engaged in a U.S. trade or business for tax purposes. This is because the tax-exempt investor could realize unrelated taxable business income and the foreign investor could be subject to U.S. taxation if the fund is considered to be engaged in a trade or business for U.S. tax purposes. Consequently, it is absolutely crucial for private equity funds to take appropriate steps to avoid being characterized as engaged in an active U.S. trade or business.

In today's market, many private equity funds are investing in distressed debt. The challenge in this context is acquiring and managing distressed debt without being viewed as engaged in the business of lending for tax purposes. Unfortunately, there is little guidance regarding when acquisition of debt rises to the level of an active lending business. However, there are some protective measures that a private equity fund can and should take if it seeks to attract foreign and/or tax-exempt investors. For instance, loans cannot be acquired by the private equity fund too soon after the initial borrowing transaction. In addition, it is critical for the private equity fund to avoid involvement in negotiations of loan terms. Given the potential impact on investment decisions, private equity funds would be well-advised to seek an opinion letter from a tax or consulting firm as to whether its activities rise to the level of an active lending business for tax purposes.

A reader emailed me the following question after reading yesterday's article:

You said that "reasonable estimate" is a term of art when it comes to estimating E&P. So what does the IRS consider to be a "reasonable estimate"?

Unfortunately, there is no clear cut answer here. The only clear guidance that the Treasury Regulations provide is that this reasonable estimate is to be made on the basis of facts and circumstances. As such, what constitutes a "reasonable estimate" can and often will vary from corporation to corporation.

Note, however, that while this reasonable estimate concept may not be a picture of clarity, the consequences of under-withholding are clear. To the extent that a corporation fails to withhold sufficient tax, that corporation is liable to the IRS for that amount. To further complicate things, if the corporation pays the obligation itself, that could potentially be considered income to the foreign shareholder. Moreover, there could in theory be a withholding obligation with respect to that additional income.

Bottom Line: If Management is going to rely on an estimate of earnings and profits to justify withholding at a reduced rate, it will want to make sure that the estimate is reasonable because the corporation will be on the hook for under-withholding.

In order to ensure proper U.S. taxation of dividends received by non-U.S. taxpayers, I.R.C. § 1441 imposes a withholding obligation on the corporation that is paying the dividend. More specifically, Section 1441(a)(1) requires the corporation that is paying the dividend to withhold a tax equal to 30% of the gross dividend amount.

Significantly, however, the determination as to whether a corporate distribution constitutes a taxable "dividend" subject to withholding cannot be made until yearend. This is because the Internal Revenue Code characterizes a corporate distribution as a taxable "dividend" only to the extent that it is paid out of the corporation's earnings and profits. See I.R.C. § 317. In some cases, a corporation may make a distribution at a point in time when yearend earnings and profits are unclear. Consequently, the extent to which the distribution constitutes a taxable "dividend" is also unclear. But if the amount of the dividend is unclear at the payment date, how does the corporation satisfy its withholding obligation?

Pursuant to I.R.C. § 1.1441-3(c), the corporation must withhold 30% of the entire distribution amount, unless the corporation can establish that the distribution is not coming out of the corporation's earnings and profits based on a reasonable estimate of yearend earnings and profits. In this respect, it should be emphasized that this reasonable estimate concept is a defined term of art under the Treasury Regulations. As such, a corporation should seek an opinion from a competent tax firm prior to withholding at less than 30%.

Things got heated this morning on the Today Show when Today's Professionals Panel discussed the topic of Star Jones' friend - Denise Rich - renouncing her U.S. citizenship, presumably to escape paying millions of dollars in U.S. taxes. Given the emphasis that was placed on tax avoidance, I thought it might be helpful to address the actual tax consequences of expatriation.

Under I.R.C. § 877, certain high-net-worth individuals who surrender their U.S. citizenship must pay a toll charge of sorts to get out of the country. In essence, the tax law treats the individual's expatriation as a realization event for tax purposes. In technical tax language, this means that the individual must "mark-to-market" all assets and pay tax currently. Interpretation: the individual is treated as having sold all assets at fair market value for tax purposes. As a result, the individual must recognize gain on this fictional sale and pay tax on the fictional gain generated. Of course, to the extent the individual's assets consist of cash or cash equivalents, there will be no gain recognition and consequently no tax. But to the extent the individual's assets consist of investments, securities, and tangible property, tax will be paid.

With that being said, Denise Rich has had her day of reckoning with the U.S. Treasury Department as far as the tax law is concerned.

In today's world of multi-national corporations and globalization, it is not uncommon for a U.S. citizen to live and work abroad in a company's foreign office. Since the U.S. citizen is earning all of his or her income abroad and paying taxes on that income abroad, there should be no tax obligations in the United States, right? Wrong.

The United States operates on a worldwide system of taxation. This means that a U.S. citizen's income is subject to U.S. taxation even if it is earned in another country. The jurisdiction to tax a U.S. citizen's foreign income comes from the fact of U.S. citizenship. As far as the tax law is concerned, U.S. citizenship carries with it certain benefits and protections that follow a U.S. citizen wherever he or she may go in the world. Receipt of these benefits and protections provides the basis for U.S. taxation. Cook v. Tait, 265 U.S. 47 (1924).

Significantly, citizenship as a basis for taxation is not very common. Indeed, only one other country has adopted this approach: the Philippines. Most other countries tax on the basis of residence, not citizenship.

Key Takeaway: If you are a U.S. citizen living abroad, you may still have a U.S. tax obligation. Many countries have lower tax rates than the U.S. In that case, you will likely owe U.S. tax to the extent the U.S. tax rate exceeds the foreign tax rate. Even if the foreign tax rate equals or exceeds the U.S. tax rate, you may still owe U.S. tax. In any event, taxpayers are always well-advised to file a return - even if they think no tax is owed - because the statute of limitations does not begin to run unless and until a tax return is filed.

I.R.C. § 904(a) provides that "[t]he total amount of [foreign tax credit] . . . shall not exceed the same proportion of the tax against which such credit is taken which the taxpayer's taxable income from sources without the United States bears to his entire taxable income for the same taxable year."

Translation: the foreign tax credit allowed is not necessarily equal to foreign taxes paid.

The foreign tax credit limitation is computed using the following formula:

U.S. tentative tax liability x [foreign source taxable income/worldwide taxable income]

The effect of this formula is to limit the foreign tax credit to U.S. taxation of foreign source income. In other words, a foreign tax credit cannot exceed the maximum U.S. tax rate. As a result, the foreign tax credit may be limited when foreign taxes are paid to a country with higher tax rates than the United States.

Example. A taxpayer has $500 U.S. source income and $500 French source income. Assume that this taxpayer is subject to a tax rate of 35% in the U.S. and a tax rate of 40% in France. Thus, this taxpayer will have paid $200 of French tax ($500 French source income * 40%).

The United States has a worldwide system of taxation. This means that U.S. taxpayers are subject to U.S. taxation with respect to both domestic and foreign source income. In the above example, this means that the taxpayer's tentative U.S. tax liability is equal to $350 (35% * $1,000 worldwide income).

The $350 tentative U.S. tax liability is then multiplied by the ratio of foreign source taxable income to worldwide taxable income. The effect of this calculation is to limit the allowable foreign tax credit to $175 - $350 x [$500 foreign source income/$1,000 worldwide taxable income]. Thus, the taxpayer's foreign tax credit would be limited to $175 despite payment of $200 in foreign tax.

In some cases, foreign source income may be recharacterized as domestic source income and vice versa. In addition, separate calculations may be required for different types of income. For these reasons, it is important for foreign taxpayers to seek advice from a tax professional who can accurately calculate domestic and foreign source income.

Do you have foreign source income? I can help you maximize your foreign tax credit and minimize your overall tax liability. Contact me today for a free consultation.