By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL
When a joint venture partnership owns a foreign subsidiary,
different U.S. tax consequences can result to a U.S. corporate
partner exiting the partnership, depending on whether: (1) the
partnership is U.S. or foreign; (2) the subsidiary is sold by the
partnership or the U.S. partner sells its interest in the
partnership; and (3) the subsidiary is a controlled foreign
corporation (CFC). Careful planning is important to minimize U.S.
To illustrate, assume a U.S. corporation (USP) owns 50% of JVP,
an entity classified as a partnership,1 and the other 50%
is owned by a foreign corporation (FP). JVP owns all of the stock
in a foreign subsidiary (FS). JVP may be a U.S. or a foreign
entity. For simplicity, we will assume JVP has no other assets, has
no liabilities, and there are no special allocations.
Generally USP might expect to exit JVP recognizing capital gain
in an amount equal to the amount received less its adjusted basis
in JVP. As discussed below, however, because JVP owns stock in a
foreign subsidiary (FS), under certain circumstances a portion of
the gain can be reclassified as ordinary income. In addition,
depending on how the exit is structured, the ordinary income
portion of the gain can be treated as a deemed dividend from FS
accompanied with foreign tax credits which can be used to reduce or
eliminate USP's U.S. tax on the deemed dividend.
JVP Sells FS. If JVP sells the stock in FS (its
foreign subsidiary), USP would include 50% of the gain in its
income in the year of the sale. Gain recognized on the sale of the
FS stock generally is capital gain, and it retains its character
when included in income by USP.2 USP's receipt of
its share of the sale proceeds upon distribution from JVP generally
should not result in additional U.S. taxation.3
Often stock in a foreign subsidiary can be sold without
incurring foreign taxes. If, however, JVP pays foreign income tax
on the gain, USP should be entitled to claim a foreign tax credit
for income taxes paid on its share of the gain,4 subject to
limitations.5 The source of the
gain on the sale of the stock in FS is determined at the partner
level, and generally should be U.S.-source under the residency rule
(subject to certain exceptions).6 Any
foreign-source capital gain should generally fall within the
passive basket,7 and foreign taxes paid
on any gain should be classified in the same basket as the gain.8
The U.S. tax results can change significantly if the foreign
subsidiary is a CFC.9 FS would be a CFC
if JVP is a U.S. partnership because FS would be wholly owned by a
The sale by a U.S. JVP of stock in FS (a CFC) is subject to
§1248.11 Under that
provision, the gain is recharacterized as dividend income to the
extent of the undistributed earnings and profits (E&P) derived
by FS while it was a CFC and owned by JVP. Such deemed dividend
generally is foreign-source income12 and
general basket income under look-through rules.13 The deemed
dividend would be accompanied with deemed-paid foreign
share of such taxes should flow through and be creditable against
U.S. taxes on the §1248 amount.15 Thus, it
is possible to significantly reduce U.S. taxes on the portion of
gain recognized by USP on exit that is treated as a dividend under
§1248 (without paying any additional foreign taxes).
If JVP instead were a foreign entity, under the above facts FS
would not be a CFC, and §1248 would not apply. However, if
USP owned more than 50% of JVP, FS would be a CFC. Although JVP
would not be a U.S. shareholder, USP would be a "United States
shareholder" and the regulations provide that §1248 is applied by
treating USP as selling its proportionate share of the stock of
the application of §1248 generally is beneficial, consideration
might be given to taking steps to cause FS to become a CFC.17
It should be noted that only E&P derived by a foreign
subsidiary after becoming a CFC are taken into account for purposes
of §1248. To access pre-CFC E&P with accompanying foreign tax
credits, FS could distribute a dividend of such E&P prior to
being sold, which can provide a result similar to the application
of §1248.18 A pre-sale
distribution might also be considered if CFC status is not obtained
USP Sells Its Interest in JVP. If USP
sells its interest in JVP (a partnership), under the general rules
any gain recognized would be capital gain.20 This is
the case whether JVP is a U.S. or foreign entity.
However, gain on the sale of an interest in a partnership can be
recharacterized as ordinary income to the extent the amount
received is for the partner's interest in the partnership's
unrealized receivables or inventory items. In relevant part,
§751(c) provides that the term "unrealized receivables" includes
the amount of gain treated as ordinary income under §1248 if stock
in a CFC owned by the partnership were sold by the
partnership.21 The §1248
amount is determined under the rules discussed
As discussed above, FS would be treated as a CFC if JVP were a
U.S. partnership. On the other hand, if JVP were a foreign
partnership, FS would not be a CFC under the above facts (unless
there is otherwise sufficient ownership by USP to cause FS to be a
Where FS is a CFC, an issue arises concerning whether the amount
of gain recognized by USP on the sale of its interest in JVP that
is treated as ordinary income under §751 is analyzed as if it were
a §1248 deemed dividend, or as if it were some unique ordinary
income inclusion. The issue is not expressly addressed in the Code,
regulations, or any published ruling. It appears that the position
of the IRS is that §1248 would not apply, apparently because the
income is ordinary under §751 and not under §1248.22
Under this view, USP would not obtain any deemed-paid taxes, and
the gain treated as ordinary income generally would be U.S.-source,
fully subject to U.S. taxation. In addition, the §751 portion of
the gain could not be reduced by capital losses.
From a policy perspective, the proper treatment would be to
adopt an aggregate approach and apply §1248 to the extent of the
amount of the gain that is recharacterized as ordinary income under
§751 by reference to §1248. This would achieve the same result as
if the partnership had sold the CFC stock. Under the approach of
the IRS, the U.S. tax result generally is worse than if the
partnership had sold the CFC stock. Thus, it would seem appropriate
for the IRS to issue guidance applying an aggregate approach for
this purpose, similar to its regulations that adopted an aggregate
approach for purposes of applying §1248 to the sale of CFC stock by
a foreign partnership.23
Exit Planning. With a U.S. JVP, the best exit
approach from a U.S. tax perspective generally is for JVP to sell
FS (a CFC) to obtain the foreign tax credit benefits provided by
§1248. If this is not feasible and USP must sell its interest in
JVP, then FS could distribute its §1248 E&P prior to the sale
and thereby USP should obtain a similar benefit.24
With a foreign JVP where FS is a CFC, a sale by JVP of FS should
provide the §1248 foreign tax credit benefits. If FS is not a
CFC or USP must sell its interest in the foreign JVP, then having
FS pay out its E&P prior to exit should provide USP with
similar foreign tax credit benefits. 25
This commentary also will appear in the April 2014 issue of
the Tax Management International Journal. For
more information, in the Tax Management Portfolios, see Stoffregan,
Harris, and Wirtz, 910 T.M., Partners and Partnerships -
International Tax Aspects, Yoder & Kemm, 930 T.M.,
CFCs - Sections 959-965 and 1248, and in Tax Practice
Series, see ¶7150, U.S. Persons - Worldwide Taxation.
4 §901(b)(5). See also §702(a)(6) and
Regs. §1.702-1(a)(6); §703(b)(3) and Regs. §1.703-1(b)(2).
The allocation of taxes among partners must have substantial
economic effect. §704(b); Regs. §1.704-1(b)(4)(viii). USP should
also be entitled to a credit for any withholding taxes paid on the
distribution by JVP of the sales proceeds to USP (even though such
distribution is not subject to U.S. taxation).
6 §865(a)(1), (g)(1)(A), (i)(5). Under
certain circumstances gain on the sale of stock in a foreign
corporation can be foreign-source income. §865(e), (f), and (h).
Foreign income taxes paid on both foreign-source and U.S.-source
gain are creditable.
9 §957 (a foreign corporation is a CFC if U.S.
persons that own at least 10% of the voting stock own in the
aggregate more than 50% of the vote or value of the stock of the
foreign corporation, taking into account stock owned indirectly and
15 See n. 4, above. Any excess foreign taxes
associated with the gain recharacterized as ordinary income under
§1248 should also be available to offset U.S. tax on other
foreign-source general basket income, and any excess foreign tax
credits USP has in the general basket should be available to offset
U.S. tax on the §1248 deemed dividend.
16 Regs. §1.1248-1(a)(4) and (5), Ex. 4.
These regulations became effective in 2007. Prior to these
regulations, apparently §1248 did not apply to a sale by a foreign
partnership of a foreign subsidiary even if it were a CFC, because
§1248 applies only when a U.S. person sells stock in a CFC, and a
foreign partnership is not a U.S. person.
See Morrison, "Section 1248's Application to the Sale
of CFC Shares by a Foreign Partnership," 32 Tax Mgmt. Int'l
J. 85 (2/14/03).
17 This might be achieved by having USP acquire a
small additional interest in JVP or a small interest in FP. Regs.
§1.957-1(c), Exs. 8 and 9. Before taking steps to cause FS
to become a CFC, the results of the application of Subpart F to FS
should be assessed.
18 §902(a); see §902(c)(7) (10% voting
test applied at partner level); Regs. §1.904-5(a)(4). The
look-thru rules for basket purposes apply to a dividend received
from a foreign corporation where the U.S. shareholder owns at least
10% of the voting stock, even if the foreign corporation is not a
CFC. §904(d)(4). See Yoder, "Look-Through for 10/50
Joint Venture Corporations: Not a Panacea," 32 Tax Mgmt. Int'l
J. 86 (2/14/03).
19 See, e.g., Litton Industries Inc.
v. Commissioner, 89 T.C. 1086 (1987); Uniroyal, Inc. v.
Commissioner, 65 T.C.M. 2690 (1993); Rev. Rul. 75-493, 1975-2
C.B. 109. Under certain circumstances a pre-sale dividend can be
integrated with the stock sale, and recharacterized as sales
proceeds. See, e.g.,Waterman Steamship Co. v. United
States, 430 F.2d 1185 (5th Cir. 1970).
22 See T.D. 9345, 72 Fed. Reg. 41442
(7/30/07), at 41443; T.D. 9644, 78 Fed. Reg. 72394 (12/2/13), at
72419; §1248(g)(2)(B); Regs. §1.1248-1(e)(2) (§1248 does not apply
to amounts treated as ordinary income under another provision of
24 If a U.S. partner cannot use foreign tax credits
(e.g., it has overall foreign losses or net operating losses) and
has substantial capital losses, consideration might be given to
using a foreign entity for a 50/50 JVP that owns a foreign
subsidiary. This should avoid ordinary income upon exit that
results under §751 or §1248 from FS's being a CFC when owned by a
25 Another common foreign joint venture structure
is for USP to have one of its wholly owned foreign subsidiaries
(i.e., a CFC) own its interest in JVP (classified as a
partnership). If FS is disregarded, most or all of the gain on exit
should not be currently subject to U.S. tax as Subpart F
income. For Subpart F purposes, the CFC partner would be
considered as deriving gain on the sale of the assets of FS,
whether it sells its interest in JVP or JVP sells the interests in
FS. §954(c)(4). Such gain would not be Subpart F income to the
extent the assets are used in a trade or business (including
intangibles). Regs. §1.954-2(e)(3). See
also Yoder, "Foreign Corporate Joint Ventures: Foreign
Tax Credit Planning," 42 Tax Mgmt. Int'l J. 482
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