CFC Sandwich Structures: Applying the DRD to Subpart F Income and CFC Dividends

By Lowell D. Yoder, Esq.

McDermott Will & Emery LLP, Chicago, IL

When a U.S. multinational acquires a foreign-owned target, it is not uncommon to inherit a structure whereby the U.S. parent indirectly owns a U.S. subsidiary through a controlled foreign corporation (CFC). This "CFC sandwich structure" can result in multiple levels of U.S. and foreign taxation when profits earned by the U.S. subsidiary ("earnings") are considered distributed up the chain to the U.S. parent.

To avoid excessive taxation, it is generally desirable to unwind a CFC sandwich structure by moving ownership of the U.S. subsidiary directly under the U.S. parent. Such restructuring, however, is not always possible from a legal perspective, and can result in substantial foreign and U.S. tax costs.1  

If it is not feasible for the U.S. parent to directly own the U.S. subsidiary, it would be desirable to have the U.S. subsidiary owned by a tax-efficient foreign holding company.  Such company should be organized in a country that has a participation exemption for dividends and capital gains, and a low or zero withholding tax on distributions to its U.S. parent. Also critical is that the foreign holding company qualify under a treaty with the United States for a reduction of the 30% U.S. withholding tax on dividends to zero or 5%.2  

Even if the U.S. withholding tax on a dividend paid by the U.S. subsidiary to its CFC parent is reduced to zero, there is still the potential for double U.S. taxation of dividends paid up the ownership chain to the U.S. parent. While Subpart F income of the CFC and dividends received by the U.S. parent are reduced by a dividends received deduction, the IRS has interpreted these rules as providing less than a 100% deduction. A better interpretation of the rules would be to not again subject to corporate tax a distribution of the U.S. subsidiary's earnings through the foreign intermediate owner up to the U.S. parent. This would result in the same amount of U.S. corporate tax that would be paid if the U.S. subsidiary were owned directly by its U.S. parent.

For example, assume that a U.S. parent (USP) owns all of the stock of a U.S. subsidiary (USS). Assume USS derives $10 million of income, and USP and USS do not elect to file a consolidated tax return. USS would pay $3.5 million of taxes to the U.S. government on its income.3 If USS distributes its $6.5 million of after-tax earnings to USP, such amount would generally be included in the income of USP as dividend income.4 However, under §243, USP is allowed to claim a deduction for 100% of the amount of the dividend received from USS.

More specifically, §243 provides that a corporation is allowed as a deduction 100% of the amount of "qualifying dividends" received from a U.S. corporation. A "qualifying dividend" is one received by a corporation that is a member of the same affiliated group as the corporation distributing the dividend.  The term "affiliated group" means one or more chains of "includible corporations" (e.g., U.S. corporations) connected through stock ownership constituting 80% of the total voting power and value of such stock.5 Therefore, since USP and USS are members of an affiliated group, USP is entitled to deduct 100% of the dividends received from USS.

USP and USS could elect to file a consolidated return for U.S. income tax purposes. The $10 million of income derived by USS would be included in the consolidated group's taxable income and subject to U.S. corporate tax of $3.5 million, as above. Under the consolidated return rules, a $6.5 million dividend received by USP from USS would be excluded from the income of USP.6  

Under the above scenarios, full corporate tax has been paid on the income derived by USS. The dividends received deduction and the exclusion of dividends under the consolidated return regulations ensure that additional U.S. corporate tax is not imposed on the earnings of USS when considered distributed to its parent corporation. 

Let's now consider a CFC sandwich structure, where USP owns a foreign subsidiary (FS) which in turn owns USS.  USS would not be allowed to file a consolidated return with USP because a foreign corporation is interposed in the ownership chain.7 Under this scenario, like the ones above, USS would pay $3.5 million of U.S. corporate income tax on its $10 million of income.

Assume that USS is considered to distribute its after-tax earnings of $6.5 million to FS, which in turn is considered to distribute the same amount to USP. Assume further that FS is organized in a country that has a treaty with the United States providing for no withholding tax on dividends, and no foreign taxes are imposed on the distributions. FS should not be subject to direct U.S. corporate taxation on the dividend received from USS, since the income is not attributable to a U.S. permanent establishment nor effectively connected with a U.S. trade or business.8

However, provided FS is a CFC, Subpart F can apply to cause the dividend income to be subject to current U.S. taxation.  Under Subpart F, a CFC's gross Subpart F income, less deductions and expenses allocated and apportioned to such income, is currently included in the gross income of the U.S. shareholder.9 Income subject to U.S. taxation under Subpart F would be taxed at a 35% rate. Such inclusions can be accompanied with deemed-paid foreign taxes, which offset U.S. tax on foreign-source income.10

Subpart F foreign personal holding company income expressly includes dividends.11 Although two exceptions are provided for dividends, they do not apply to dividends received from a U.S. subsidiary.12 Specifically, the temporary look-through exception that applies to dividends received by one CFC from a related CFC would not apply to such dividends.13 In addition, the exception that applies to dividends received from a related corporation organized in the same country as the CFC would not apply to a dividend received from USS.14 Therefore, the $6.5 million dividend received by FS from USS would be Subpart F income.15

In calculating the net Subpart F dividend income of FS, the dividends received deduction provided by §243 should apply. That section applies to dividends received from a U.S. corporation by a "corporation." There is no requirement that the recipient be a U.S. corporation to be eligible for the deduction.

The Subpart F regulations provide generally that a foreign corporation is treated as a U.S. corporation for purposes of determining the CFC's gross income and taxable income for Subpart F purposes.16 If FS were treated as a U.S. corporation, it should be entitled to deduct 100% of the $6.5 million dividend received from USS (the same result as USP receiving a dividend from USS).

The IRS issued a private letter ruling confirming that the dividends received deduction provided by §243 is available for purposes of computing net Subpart F income.17 However, the IRS allowed only an 80% deduction.  Section 243 allows a deduction for 80% of a dividend received from a U.S. corporation where the corporation receiving the dividend owns at least 20% of the stock of the distributing corporation. Under the approach of the IRS, $1.3 million of the dividend received by FS from USS would be included in the gross income of USP under Subpart F (i.e., $6.5 million x 20%).18  

The IRS did not allow a 100% deduction apparently because the recipient was a foreign corporation. As mentioned above, the 100% deduction is available for a qualifying dividend, which is a dividend received by a corporation that is a member of the same affiliated group as the U.S. corporation distributing the dividend.  Foreign corporations are excluded from the definition of an affiliated group.19 Nevertheless, as mentioned above, the §952 regulations state that a CFC should be treated as a U.S. corporation for purposes of calculating its gross income and net Subpart F income.  It is unclear why the IRS did not apply the literal language of the regulations and allow a 100% deduction, which would clearly provide a more appropriate result of eliminating double U.S. corporate taxation of the earnings of the U.S. subsidiary.

Is the $1.3 million Subpart F inclusion in the income of USP eligible for the dividends received deduction provided by §245? As discussed below, an actual dividend received by USP from FS out of earnings FS received from USS is eligible for a dividends received deduction under §245. This rule, however, applies to a "dividend," and Subpart F does not expressly state that the amount included in the income of the U.S. shareholder is a dividend; it merely provides that the U.S. shareholder must "include" the Subpart F amounts in its gross income. Nevertheless, it would be appropriate for the IRS to treat the Subpart F inclusion as a dividend for purposes of the dividends received deduction to avoid double corporate taxation of the income of USS. The IRS on several occasions has concluded that a Subpart F inclusion, which is essentially treated like a deemed dividend, should be considered as a dividend to provide the appropriate results for taxpayers.20  

The PLR, however, does not expressly address this issue. In the absence of guidance, there would be uncertainty in taking the position that Subpart F inclusions qualify for a dividends received deduction. Accordingly, under the apparent view of the IRS, U.S. corporate tax at a 35% rate would be paid by USP on 20% of the dividend received by FS from USS, or $455,000 of additional U.S. tax.21  

The next step is for FS to distribute the $6.5 million to USP. Under the approach of the PLR, $1.3 million of the distribution would be previously taxed income excluded from the income of USP.22 The remaining $5.2 million would generally be included in the income of USP as dividend income.23  

As mentioned above, §245 provides a deduction for the "U.S.-source" portion of dividends received by a corporation from an 80%-owned foreign corporation. The deduction generally is 80% of the amount of such dividends.24 For this purpose, "U.S.-source earnings" are earnings of the foreign corporation that are effectively connected with the conduct of a U.S. trade or business in the United States, and any dividends received (directly or through a wholly owned foreign corporation) from a U.S. corporation.25  

Section 245(b) provides a 100% deduction for dividends received from a foreign corporation by a U.S. corporation that meets certain ownership requirements and all of its gross income from all sources is effectively connected with the conduct of a U.S. trade or business within the United States. Since the income of FS is not effectively connected with a U.S. trade or business, the 100% deduction does not appear to be available.26 It would seem entirely appropriate to apply the 100% deduction to a distribution received by USP from FS attributable to USS dividends, as such income would have been subject to full U.S. corporate taxation.

The PLR concluded that the U.S. shareholder could deduct 80% of the dividend received from the foreign subsidiary that was attributable to the dividend received from the U.S. subsidiary.  Therefore, under the facts herein, USP would be entitled to deduct 80% of the $5.2 million taxable portion of the distribution received from FS, resulting in taxable income of $1.04 million, and taxes of $364,000.27  

Thus, the taxation of the distribution of a dividend from USS up through FS to USP would result in additional U.S. taxes of $819,000 (i.e., 20% of the dividend is taxable at each level). This results in an effective U.S. federal tax rate of 43% on the earnings of USS distributed to USP ($4,319,000 of total U.S. taxes).28  

The amount of the earnings of USS subject to double U.S. corporate taxation would increase if there were more than one intermediate foreign corporation. Under the IRS view, 20% of the amount of the taxable dividend received by each foreign intermediary corporation would be subject to U.S. taxation under Subpart F.29 Thus, to the extent possible, it would be desirable to minimize the number of CFCs in the chain of ownership between USP and USS.

Another rule of Subpart F can potentially cause all of the earnings of USS to be subject to double U.S. corporate taxation. Sections 951(a)(1)(B) and 956 require an inclusion in the gross income of U.S. shareholders of the amount of the CFC's non-previously taxed earnings invested in U.S. property. Stock in a U.S. subsidiary is U.S. property. If FS does not distribute the amount of the dividend received from USS, such earnings would be subject to this rule.30

  

For example, assume that FS has $25 million of basis in the stock of USS, and FS does not distribute to USP the $6.5 million received from USS. If the only earnings and profits of FS consist of the $6.5 million dividend received from USS, FS would have $5.2 million of untaxed earnings and $1.3 million of previously taxed earnings. Under §956, the $5.2 million would be included in the income of USP.31 As mentioned above, the IRS does not appear to permit a dividends received deduction for Subpart F inclusions. This would result in full double taxation of the USS dividend of $6.5 million ($1.3 million as Subpart F income and $5.2 million as an investment in U.S. property), causing USP to pay $2,275,000 of additional taxes (an effective tax rate of 58%).32 The $6.5 million can subsequently be distributed by FS to USP without additional U.S. tax as previously taxed income.33 Thus, it would be desirable for FS to distribute the $6.5 million of earnings in the same year received to avoid the additional U.S. tax costs resulting from the application of §956.34

The IRS has appropriately concluded that the dividends received deduction applies to dividends paid from a U.S. subsidiary through a CFC sandwich structure to the U.S. parent, thereby ameliorating double U.S. corporate taxation. However, the IRS position apparently is to permit only an 80% deduction against Subpart F income at the CFC level and only an 80% deduction for CFC dividends received by the U.S. parent, and no deduction against Subpart F inclusions in the income of the U.S. parent. Rather, a 100% deduction is required to carry out the fundamental policy of subjecting corporate group earnings to only one level of U.S. corporate tax.

This commentary also will appear in the October 2011 issue of the Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Maule, 503 T.M., Deductions: Overview and Conceptual Aspects, and Yoder, Lyon, and Noren, 926 T.M., CFCs — General Overview,  and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.


1 Gain resulting from a transfer of the stock of the U.S. subsidiary would be Subpart F income includible in the income of the U.S. parent. (In certain circumstances a §338 election can be made for the foreign owner of the U.S. subsidiary to eliminate the gain.) In addition, if the U.S. subsidiary is a United States real property holding corporation, U.S. tax can apply directly to any built-in gain realized in connection with taxable and certain tax-free transfers of the stock of the U.S. subsidiary (including a deemed transfer of the U.S. subsidiary's stock under §338). §897; Regs. §1.897-5T; Notice 2006-46, 2006-1 C.B. 1044.

  2 Possible countries in which a tax-efficient foreign holding company may be organized include Luxembourg, the Netherlands, and the United Kingdom.

  3 For purposes of illustration, graduated tax rates are ignored.

  4 §§61(a)(7), 301(a) and (c)(1).

  5 §§243(b)(2)(A), 1504(a).

  6 Regs. §1.1502-13(f)(2)(ii).

  7 §1504(a) and (b)(3).

  8 §§881, 882.

  9 §§951(a)(1)(A), 952(a), 954(a), (b)(5); Regs. §1.954-1(a)(4), (c).

  10 §960.

  11 §954(c)(1)(A).

  12 Another exception applies to U.S.-source income that is effectively connected with a U.S. trade or business of the CFC, but that exception would not apply to the dividend received by FS from USS. §952(b).

  13 §954(c)(6). 

  14 §954(c)(3)(A)(i).

  15 The de minimis or high-tax exception may be available. §954(b)(3) and (4).

  16 Regs. §1.952-2(a)(1) and (b)(1). There are express exceptions for certain deductions, but these exceptions do not limit the application of the dividends received deduction. Regs. §1.952-2(c)(1).

  17 PLR 200952031 (12/24/09).

  18 FS might have other expenses that are allocated or apportioned to the USS dividend income, further reducing the amount of the Subpart F income inclusion.

  19 §1504(b)(3).

  20 See, e.g., PLR 8836037 (Subpart F inclusions treated as dividends for purposes of calculating UBTI); PLR 201129002 (Subpart F income treated as income derived with respect to a RIC's business of investing in the stock of a subsidiary); but see Notice 2004-70, 2004-2 C.B. 724 (Subpart F inclusions not treated as dividends for purposes of §1(h)(11)); cf. §245(a)(11) (the term "dividend" does not include any amount treated as a dividend under §1248), §904(h)(10) (treats Subpart F inclusions as dividends in certain circumstances).

  21 Section 904(h) provides that U.S.-source Subpart F income is treated as U.S.-source income of the U.S. shareholder, and thus U.S. tax cannot be reduced with foreign tax credits. Nevertheless, under certain circumstances the U.S.-source dividend may be accompanied with deemed-paid taxes under §960 that may be used to reduce U.S. tax on USP's foreign-source income.  See also §904(h)(10) (income may, by election, be treated as separate basket foreign-source income if a treaty applies).  Cf. §245(a)(8), (9), (10).

  22 §959(a).

  23 The dividends received deduction applicable to the dividend received by FS from USS would not reduce the earnings and profits of FS. PLR 200952031, above, citing Weyerhaeuser v. Comr., 33 B.T.A. 594 (1935). See also Dileo v. Comr., 96 T.C. 858 (1991), aff'd, 959 F.2d 16 (2d Cir. 1992).

  24 §245(a)(1). If FS has other earnings and profits, the amount of the dividend considered as paid out of U.S.-source earnings is a pro rata amount of the post-1986 undistributed earnings of FS. §245(a)(3).

  25 §245(a)(5).

  26 If a former U.S. corporation reincorporates in a foreign jurisdiction and pays a dividend out of earnings and profits accumulated during the period when it was a U.S. corporation, the dividend is not treated as a dividend received from a foreign corporation, and is eligible for the dividends received deduction provided by §243. §243(e); Regs. §§1.243-3(a)(1), 1.245-1(c)(2).

  27 No foreign tax credit is allowed for any taxes paid or accrued (or treated as paid or accrued) with respect to the U.S.-source dividend eligible for the deduction, and such dividend is treated as from sources within the United States.  §245(a)(8), (9). If a treaty applies to treat such amounts as foreign-source income, a taxpayer can choose to forgo the dividends received deduction and use foreign tax credits, but the foreign tax credit rules would be applied separately with respect to the dividend.  §245(a)(10). Cf. §904(h).

  28 There may also be state income taxes imposed on the income.

  29 A foreign parent of FS that receives a dividend from FS attributable to earnings of USS should be entitled to an 80% dividends received deduction under §245. Currently, §954(c)(6) can apply to exclude from a CFC parent's income dividends received from a CFC subsidiary, but that provision is temporary. But see Notice 2007-9, 2007-1 C.B. 401, §7(c).

  30 The amount subject to inclusion under §956 is limited to earnings and profits of the CFC that were not previously subject to U.S. taxation under Subpart F. Under ordering rules, for this purpose a CFC's earnings and profits are reduced by distributions during the year and take into account previously taxed income resulting from current year Subpart F income. On the other hand, Subpart F income inclusions are determined before taking into account any dividend distributions during the year and before §956 is applied.

  31 But see §956(b)(2) (special rule for property acquired before corporation was a CFC).

  32 USS would pay $3,500,000 on its $10 million of income, and USP would pay an additional $2,275,000 on the distribution of the earnings to FS, or a total U.S. tax cost of $5,775,000. The amount of U.S. taxation imposed on the earnings of USS would become even more onerous if the 30% U.S. withholding tax applied to the dividend paid by USS to FS.

  33 §959(a).

  34 The dividend would not qualify for the exception provided by §954(c)(6) to the extent it reduces the §956 inclusion. See Notice 2007-9, above.