Should the United States Adopt a “Managed and Controlled” Test for Offshore Investment Funds?

By Kenneth J. Krupsky, Esq. Jones Day,Washington, DC

Generally speaking, the United States imposes its net income tax on the worldwide income of all U.S. corporations - i.e., corporations incorporated in the United States. Our net income tax generally applies to a foreign corporation - i.e., a corporation incorporated outside the United States -- only if the corporation is engaged in a U.S. trade or business, and then only as to its U.S.-source and certain limited foreign-source income that is “effectively connected” with that U.S. business (notable additional instances of taxation being expatriations of former U.S. corporations under §7874 and dispositions of U.S. real property under §897). Moreover, under §864, a foreign corporation is not taxed on income from trading for its own account in the United States in stocks, securities, or (perish the thought) derivatives, including trading through an investment manager or its own employees in the United States who exercise investment discretion.

Not so in the United Kingdom. The U.K. corporation income tax applies to the worldwide income of: (1) any company incorporated in the United Kingdom; and (2) any foreign-incorporated company that is “managed and controlled” in the United Kingdom. Generally speaking, management and control is where the board of directors meets, assuming the board is “managing” the company. If the board is a mere “cipher,” and the real decisions are made elsewhere, management and control will reside where the real decisions are taken. Importantly, the relevant management decisions are those of high-level strategic management, rather than immediate management of day-to-day activities. For foreign investment companies, standard U.K. tax advice is that all “high-level” decisions must be made offshore, the board must meet offshore, and a majority of the board should be non-U.K. residents (e.g., two out of three). In contrast to the board, the company's investment adviser can be in the United Kingdom without causing the company to be taxable on a “U.K. trade” (although the adviser may then be subject to relevant financial services regulation). This “investment manager exemption” generally requires that: (1) the onshore manager act in an independent capacity; (2) the remuneration of the manager be at arm's length; and (3) the interest of the investment manager in the income of the investment company not exceed a certain threshold over time.

Should the United States adopt a variation of the U.K. “managed and controlled” test? On March 2, 2009, Senator Levin introduced the “Stop Tax Haven Abuse Act” (S. 506) (the “Bill”). Congressman Doggett introduced an identical bill (H.R. 1265) on March 3. Treasury Secretary Geithner was quoted on March 5 as saying he “fully supports” the Bill. As widely noted, in 2007, then-Senator Obama was a co-sponsor of a similar 2007 bill from Senator Levin. The new Bill has many of the 2007 provisions, including measures aimed at U.S. taxpayers (mostly individuals) who seek to “hide” assets in offshore tax havens and codification of the “economic substance doctrine.”

The new Bill has a new provision, which would import into U.S. law, I believe for the first time, a variation of the U.K. “managed and controlled” test. Section 103 of the Bill would add to the Code a new §7701(o), entitled “CERTAIN CORPORATIONS MANAGED AND CONTROLLED IN THE UNITED STATES TREATED AS DOMESTIC FOR INCOME TAX.” A nice clear title. The test for taxing a foreign corporation's worldwide income is also stated simply: “the management and control of the corporation occurs, directly or indirectly, primarily within the United States.”

Not all foreign corporations would be covered by the new rule. Covered foreign corporations are those where either: (1) the corporation's stock is regularly traded on an established securities market; or (2) the aggregate gross assets of the corporation (or any predecessor), “including assets under management for investors,” whether held directly or indirectly, at any time during the year or any preceding year is $50 million or more. The “including” phrase is interesting. Assets which are “of” the corporation presumably means all assets beneficially “owned” by the corporation for tax purposes. So why mention assets “under management for investors”? Perhaps the drafters were concerned to cover cases where assets legally titled in the corporation were being managed for the beneficial owners of the assets, who might no be the owners of the corporation. Does this mean that assets legally held in “street name” by a manager are assets “of” the corporation? Surely a domestic corporation would not be taxed in this situation.

Then there is a “general exception” to the general rule. A corporation is not covered if: (1) the corporation was covered in a preceding year; (2) the corporation is not regularly traded and has and is reasonably expected to continue to have gross assets of less than $50 million; and (3) the Secretary grants a waiver. What are the criteria under which the IRS will grant or not grant a waiver? Is the IRS to predict (like Warren Buffet) the growth of the assets?

Next is an exception to the $50 million assets test. That test is treated as not met by a corporation which is a controlled foreign corporation (CFC), if: (1) the parent of the CFC is a U.S. corporation; and (2) the parent has substantial assets (other than cash and stock of foreign subsidiaries) held for use in the active conduct of a U.S. trade or business. So, a CFC of a U.S. investment company parent, which is not engaged in an active U.S. business, may be covered. Likewise, a CFC owned by any U.S. partnership, including an investment partnership or a U.S. active business partnership, may be covered. Query if the CFC exception should be so narrowly written.

The Bill gives the Treasury specific direction in determining whether management and control occurs primarily within the United States. The regulations “shall provide” that: (1) management and control occurs primarily within the United States “if substantially all of the executive officers and senior management of the corporation who exercise day-to-day responsibility for making decisions involving strategic, financial, and operational policies of the corporation are located primarily within the United States”: and (2) individuals who are not executive officers and senior management (including individuals who are officers or employees of other corporations in the same chain) shall be treated as executive officers and senior management “if such individuals exercise the day-to-day responsibilities of the corporation.” In addition, the regulations shall provide that management and control occurs primarily within the United States if: (1) the assets of the corporation (directly or indirectly) consist primarily of assets being managed on behalf of investors; and (2) decisions about how to invest the assets are made in the United States.” So the Bill significantly varies the U.K. test -- it is not the board of directors that matters, but instead the day-to-day managers. This is indeed closer to the existing U.S. test for foreign-source income that is treated as effectively connected with a U.S. trade or business. But it almost entirely guts the long-standing §864 exception for trading for one's own account.

To give offshore investment funds and others some time to restructure (if such is possible), the new provision is to be effective for taxable years beginning on or after two years after enactment. In introducing the Bill, Senator Levin said the following: “Section 103 is intended to stop, in particular, the outrageous tax dodging that now goes on by too many hedge funds and investment management businesses that structure themselves to appear to be foreign entities, even though their key decision makers -- folks who exercise control of the company, its assets, and investment decisions -- live and work right here in the United States.…It is unacceptable that such companies utilize U.S. offices, personnel, laws, and markets to make their money, but then stiff Uncle Sam and offload their tax burden onto competitors who play by the rules.” Just the kind of new tax provision we need right now. For all those U.S. investment fund managers who are now unemployed, or under-employed, in New York, Los Angeles, and Kansas City, it's time to move to London (but please make sure two out of three of the fund's directors remain in the United States, or elsewhere outside the United Kingdom)!

This commentary also will appear in the May 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Streng, 700 T.M., Choice of Entity, and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.