Foreign Corporate Joint Ventures: Foreign Tax Credit Planning

By Lowell D. Yoder, Esq.  

McDermott Will & Emery LLPChicago, IL

U.S. multinationals commonly enter into foreign joint ventures with foreign companies. One important tax consideration is the application of the foreign tax credit rules with respect to income derived from the joint venture. When the foreign joint venture is a corporation, planning into status as a controlled foreign corporation (CFC) can be beneficial.

To illustrate, assume a U.S. multinational (USP) enters into a foreign joint venture (FJV) with a foreign company (FP) to conduct business outside the United States (e.g., in China). The FJV is a corporation for U.S. tax purposes (FJV), and derives income from the manufacture and sale of products, and from providing services.  USP may receive dividends, interest, rents, and royalties from FJV, and ultimately realize gain on the sale of its stock in FJV.

Credit for Foreign Taxes.  As a general rule, foreign withholding taxes paid by USP on dividends, interest, rents, or royalties received from FJV are creditable taxes.  Such items of income generally would be foreign-source,1 and thus any foreign withholding taxes can be claimed as a credit against U.S. income taxes on such amounts (subject to limitations).2

In addition, if USP owns at least 10% of the voting stock of FJV, when USP receives a dividend from FJV, USP is deemed to have paid the foreign taxes that FJV paid with respect to the earnings and profits considered distributed as a dividend to USP.3 For example, assume FJV is subject to a 25% foreign tax rate on its income for foreign tax purposes and assume equivalency between after-tax income for foreign tax purposes and earnings and profits. A dividend of $15 million paid to USP would generally be accompanied with $5 million of deemed-paid foreign taxes. The amount received would be "grossed up" for the taxes and thus USP would report $20 million of income.4 U.S. tax of $7 million would be reduced by a foreign tax credit of $5 million, with net U.S. tax of $2 million.5

The amount of foreign taxes that can be claimed as a credit is limited to the amount of preliminary U.S. tax on foreign-source income. This limitation is computed separately for passive foreign-source income and active (or general basket) foreign-source income.6 Accordingly, excess taxes paid on an item of high-taxed general basket income can be used to offset U.S. tax on an item of low-taxed general basket income, but such excess taxes cannot be used to offset U.S. tax on low-taxed passive basket income. Foreign taxes that qualify as income taxes for purposes of the foreign tax credit are referred to as "foreign tax credits," even though their creditability might in fact be limited by the foreign tax credit limitations.

As a general rule, it is desirable for dividends, interest, rents, and royalties received from FJV to fall within the general basket because most of the time a company's excess foreign tax credits (if any) are within the general basket. It is seldom the case that U.S. tax on passive income is reduced with excess foreign tax credits.7

Foreign Tax Credit Category. Dividends, interest, rents, and royalties received from a foreign corporation generally fall within the passive basket8 because "passive income" is defined as income that would be foreign personal holding company income under the Subpart F rules.However, there are several exceptions under which an item may fall within the general basket.

Under one exception, look-through rules apply when a foreign corporation is a CFC. A foreign corporation is a CFC if U.S. persons that own at least 10% of the voting stock own in the aggregate stock in the corporation with more than 50% of the vote or value. Direct, indirect, and constructive ownership rules apply.10

Under the look-through rules that apply to CFCs, dividends, interest, rents, and royalties are classified based on the underlying income of the CFC.11 Thus, if FJV is a CFC and earns only income from sales and services - such income falls within the general category - then dividends, interest, rents, and royalties received by USP from FJV would be classified as general basket income. For example, general basket excess foreign tax credits of USP could reduce U.S. taxes on royalties subject to a 10% withholding tax. The above payments would be passive only to the extent they are considered paid out of passive income of FJV.

A look-through rule also applies to dividends received from a foreign joint venture corporation that is not a CFC if the U.S. shareholder owns stock with at least 10% of the voting power (e.g., where USP and FP each own 50% of FJV).12 Look-through treatment, however, is not available for interest, rents, and royalties received from a foreign joint venture corporation that is not a CFC.

Royalties received by USP from a non-CFC FJV can be classified as general basket income if USP satisfies an active business exception. For this purpose, the activities of USP's affiliated group (including its CFCs) are taken into account.13 Royalties are considered derived in the conduct of an active trade or business if the USP affiliated group developed, created, or produced the licensed intangible property, or acquired the intangible property and added substantial value thereto.  In addition, the active business test is satisfied if the USP affiliated group, through its own employees, regularly engages in marketing and servicing the intangible property and such organization is substantial in relation to the royalties derived from licensing such intangible property.14 

Gain on the Sale of FJV Stock. USP may ultimately sell its stock in FJV, and any foreign taxes paid on the gain generally are creditable. Nevertheless, such gain normally is U.S.-source income and, if so, U.S. tax on the gain cannot be reduced with foreign tax credits.15 Under certain circumstances, however, gain on the sale of stock in a foreign corporation can be foreign-source income and, in such cases, U.S. tax can be reduced with any foreign taxes paid on the gain.16 Generally, foreign-source gain on the sale of stock is within the passive basket (or a separate basket when a treaty is relied on for sourcing).17 Thus, as a general rule, excess foreign tax credits are not available to reduce U.S. tax on the gain.18

However, if FJV is a CFC, then gain realized by USP on the sale of its shares in FJV is generally recharacterized as dividend income to the extent of FJV's earnings and profits allocable to such shares.19 Such deemed dividend generally is foreign-source20 and general basket income under look-through rules,21 and is accompanied with deemed-paid foreign taxes.22 Thus, U.S. tax on the deemed-dividend income can be offset with any foreign taxes imposed on the gain reclassified as a dividend, deemed-paid taxes accompanying the deemed dividend, and any excess foreign tax credits in the general basket.

This deemed-dividend rule is not available for foreign joint venture corporations that are not CFCs. If FJV is not a CFC, consideration may be given to having FJV pay a dividend before the sale. This could effectively convert a portion of the sales proceeds into dividend income which falls within the general basket and is accompanied with deemed-paid foreign taxes.23

Achieving CFC Status.  If USP does not own more than 50% of FJV, consideration may be given to taking steps to cause FJV to become a CFC. There are several alternatives.  Under one approach, USP could obtain slightly more than 50% of the value (not vote) through a second class of stock.24 Another way to obtain CFC status for FJV is for USP to acquire a small amount of stock in FP, the foreign joint venture partner, and under the indirect ownership rules USP would be considered as owning a proportionate amount of the stock in FJV, giving USP a greater-than-50% interest in FJV.25 Finally, if USP has an option to purchase a few shares of FJV from FP, it would be considered as owning those shares, and thus the 50/50 FJV would be a CFC.26 Before taking such steps, however, a taxpayer must carefully consider the results of having FJV's income and investments become subject to the Subpart F rules.27

In summary, foreign tax credit benefits can be significantly enhanced if FJV is a CFC, including the ability to use excess credits to offset taxes on interest, rents, and royalties received from FJV and the ability to treat all or a portion of gain on the sale of FJV stock as a dividend accompanied with deemed-paid taxes. There are planning alternatives to achieve CFC status if USP owns 50%-or-less of FJV; nevertheless, the consequences of having the Subpart F rules apply to FJV must be carefully analyzed.28

This commentary also will appear in the August 2013 issue of the  Tax Management International Journal.  For more information, in the Tax Management Portfolios, see DuPuy and Dolan, 901 T.M., The Creditability of Foreign Taxes - General Issues, Carr and Moetell, 902 T.M., Indirect Foreign Tax Credits, Suringa, 904 T.M., The Foreign Tax Credit Limitation Under Section 904, and Yoder & Kemm, 930 T.M., CFCs - Sections 959-965 and 1248,  and in Tax Practice Series, see ¶7150, U.S. Persons - Worldwide Taxation.

Copyright©2013 by The Bureau of National Affairs, Inc.

  1 §§861, 862. Foreign-source income generally includes dividends and interest received from a foreign corporation, and rents and royalties from property located outside the United States or used outside the United States.

  2 §§901, 904.

  3 §902.

  4 §78.

  5 This is a simplified example, as there are numerous complexities in determining the amount of the deemed paid taxes and the amount that may be used as a credit. Regs. §1.902-2.

  6 §904(d)(1). Foreign tax credits not used in a year may be carried back one year and carried forward 10 years. §904(c).

  7 Passive income that is subject to a 35% or higher foreign tax rate is reclassified as general basket income. §904(d)(2)(F); Regs. §1.904-4(c).

  8 §904(d)(2)(B); Regs. §1.904-4(b).

  9 §954(c).

  10 §§957, 958.

  11 §904(d)(3)(A)-(D); Regs. §1.904-5(b), (c).

  12 §904(d)(4); Regs. §1.904-5(c)(4)(iii).

  13 Regs. §1.904-4(b)(2)(iii).  An affiliated group is defined by reference to §1504(a), and includes CFCs. If FJV is not a CFC, its activities would not be taken into account for purposes of this active business test.

  14 §954(c)(2)(A); Regs. §1.954-2(d).  See also Regs. §1.954-2(b)(6), (c) (active trade or business exception for rents, which test is also applied on an affiliated group basis for purposes of determining the foreign tax credit category); §954(h) (exception for active financing income).

  15 §865(a)(1), (g)(1)(A).

  16 §865(f), (h). See also §904(f)(3)(D) (resourcing rule for gain on the disposition of CFC stock for purposes of the overall foreign loss rules).

  17 Regs. §§1.904-4(b)(2)(i)(A),-5(c)(4)(iv), Ex. 2; §865(h)(1)(B).

  18 §904(d)(1)(A).  Any foreign taxes paid on the gain on the sale of the FJV stock that is U.S.-source generally would fall within the passive basket, although they may be moved to the general basket under the "high-tax kick-out" rule. Regs. §1.904-4(c)(1).

  19 §1248. Generally, the amount of earnings and profits taken into account is the pro rata share of the earnings and profits of the foreign corporation accumulated during the period the stock was held by the shareholder while the corporation was a CFC.

  20 §865(k)(1).

  21 §904(d)(3); Regs. §1.904-5(c)(4)(iv), Ex. 2.

  22 §1248(a); Regs. §1.1248-1(a) and (d).

  23 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).

  24 Regs. §1.957-1(c), Ex. 8.

  25 Regs. §1.957-1(c), Ex. 9.

  26 Regs. §1.958-2(e). Inserting a U.S. partnership between the partners and FJV would also cause FJV to be a CFC. Regs. §1.701-1(f), Ex. 3. Cf.  Framatone Connectors USA Inc. v. Commissioner, 118 T.C. 32 (2002), aff'd, 2004-2 USTC ¶50,364 (2d Cir. 2004) (where a taxpayer owned 50% in a Japanese joint venture corporation and did not implement any of the alternatives described above to achieve CFC status, the court rejected the taxpayer's assertion that it effectively had control of the Japanese corporation, causing it to be a CFC, and therefore denied application of the foreign tax credit look-through rules that applied to CFC dividends during the year in issue).

  27 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 FJV, and elect to classify FJV as a partnership. Such structure has similar foreign tax credit results, but there are important differences (e.g., with the sale of the interest in the partnership; see §954(c)(1)(B)).  This structure also provides deferral opportunities, although it requires navigating the often complex partnership rules, including the special rules that apply for Subpart F purposes.

  28 Planning into CFC status becomes less important if the U.S. partner does not have excess foreign tax credits, although reclassifying gain as a dividend on the sale of FJV under §1248 can alone be an important consideration.