Domestic Partnerships Treated as Foreign for Purposes of §951(a)

By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL

The Treasury and IRS announced in Notice 2010-411  (the "Notice") their intention to issue regulations that would treat domestic partnerships as foreign partnerships in applying one aspect of Subpart F. This treatment would apply for the purpose of identifying the U.S. shareholders of a controlled foreign corporation (CFC) that are required to include in gross income the amounts specified in §951(a).2  Such amounts include Subpart F income and amounts determined under §956 (i.e., investments in U.S. property). The Notice is aimed at a structure that avoided current taxation of Subpart F amounts of CFCs owned by domestic partnerships with CFC partners.

The Notice illustrates the application of the new rule with the following scenario. U.S. parent corporation (USP) owns all of the stock of two first-tier CFCs (CFC1 and CFC2). The two CFCs are partners in a domestic partnership (DPS). DPS owns all of the stock of a third CFC (CFC3). Assume that during 2011 CFC3 earns $100 of interest income that is classified as Subpart F income.

Only U.S. shareholders are required to include in their gross incomes their pro rata shares of a CFC's Subpart F income.3  A U.S. shareholder is a U.S. person that owns 10% or more of the total combined voting power of all classes of stock entitled to vote of the CFC.4  For this purpose, stock owned directly, indirectly, and constructively is taken into account.5 

A U.S. person includes a "domestic corporation" and a "domestic partnership."6  A corporation or partnership is "domestic" if it is created or organized under the laws of the United States or any state.7 

Under the facts of the above example, DPS is a U.S. shareholder of CFC3, because DPS is a U.S. person that directly owns 100% of the stock of CFC3. (Under §7701(a)(1), a partnership is considered a person.) In addition, USP is a U.S. shareholder in CFC3, because USP is a U.S. person that constructively owns 100% of the stock of CFC3. CFC1 and CFC2 are considered as owning proportionate amounts of the CFC3 stock owned by DPS, and USP is considered as owning all of the CFC3 stock considered as owned by CFC1 and CFC2.8 

Without an additional rule, the $100 of CFC3's Subpart F income would be included in the incomes of both DPS and USP. To prevent double counting, the Code and regulations provide that only U.S. shareholders that own stock directly and indirectly through one or more foreign entities must include in their gross incomes the §951(a) amounts.9  Accordingly, only the first U.S. shareholders in the chain of ownership of a CFC include the Subpart F amounts in their gross incomes.

In the above example, DPS directly owns 100% of the stock of CFC3, and therefore includes the $100 of Subpart F income in its gross income. While USP also is a U.S. shareholder in CFC3, its ownership is not indirectly through only foreign entities, but rather a domestic entity is in the chain of ownership, i.e., DPS.  Therefore, under the Code and regulations before the rule announced in Notice 2010-41, USP would not include any of CFC3's Subpart F amounts in its gross income.

Because DPS is a partnership, it is not subject to taxation, but its income is included in the incomes of CFC1 and CFC2.10  CFC1 and CFC2 are not subject to direct U.S. taxation on their distributive shares of the Subpart F amounts because they are foreign corporations.11  In addition, the Code and regulations do not appear to treat a CFC's distributive share of Subpart F income as part of that CFC's Subpart F income.12  Accordingly, it appears that CFC3's Subpart F income that is included in the gross income of DPS would not be subject to U.S. taxation under Subpart F.

The new regulations announced by the Notice will treat DPS as a foreign partnership for purposes of identifying the U.S. shareholders of CFC3 that are required to include in gross income the amounts specified in §951(a). The new rule applies where a partnership is a U.S. shareholder of a CFC and, if the partnership were foreign, the foreign corporation would continue to be a CFC and at least one U.S. shareholder of the CFC would be treated as owning stock under §958(a) (i.e., directly and indirectly through foreign entities) and would be required to include an amount in gross income under §951(a) with respect to the CFC.

Under the new rule, DPS will not be considered a U.S. shareholder for purposes of §951(a). USP would be considered a U.S. shareholder that owns 100% of CFC3 indirectly through foreign entities (i.e., CFC1 and CFC2, which own all of DPS, which would be treated as foreign). Thus, USP would include the $100 of CFC3's Subpart F interest income in its gross income.13 

The Notice provides that DPS is treated as a foreign partnership "solely" for purposes of applying §951(a).  DPS will be treated as a domestic partnership for all other purposes of the Code, including for purposes of the other Subpart F rules.14  This approach raises some questions with respect to the treatment of a distribution of CFC3's previously taxed income (PTI) that would have been included in the gross income of USP. The new regulations should clarify that a distribution of CFC3's $100 of PTI through the chain of ownership to USP should not again be subject to U.S. taxation.

The Code and regulations provide rules to prevent double taxation of the amounts included in the income of a U.S. shareholder under §951(a). Section 959(a) provides that earnings and profits of a CFC attributable to amounts included in the gross income of a U.S. shareholder (i.e., PTI) shall not, when such amounts are distributed to such shareholder directly or indirectly through a chain of ownership described under §958(a), be again included in the gross income of such U.S. shareholder. In addition, §959(b) provides that earnings and profits of a CFC attributable to amounts included in the gross income of a U.S. shareholder shall not, when distributed through a chain of ownership described under §958(a), be also included in the gross income of another CFC in such chain for purposes of the application of §951(a) with respect to such U.S. shareholder.  Distributions made by a CFC are treated as made first out of PTI to the extent thereof.15 

A distribution of the $100 of PTI by CFC3 to DPS generally would be included in the income of DPS as a taxable dividend. Section 959(a) does not seem to apply to exclude such amount from the income of DPS because, even though DPS is a U.S. shareholder, it would not have included the Subpart F income in its gross income.  Section 959(a) provides an exclusion for PTI received by only the U.S. shareholders that included the Subpart F amounts in their gross incomes (and for certain successors in interest).

The $100 dividend received by DPS would be allocated to the CFC partners. CFC1 and CFC2 should be considered as deriving a proportionate share of the dividend, which generally would be considered as Subpart F income.16  There may be a technical question concerning whether §959(b) would be available to exclude such amounts from the Subpart F incomes of CFC1 and CFC2. That provision applies to PTI distributed though a chain of ownership described in §958(a), but DPS, treated as a domestic partnership for this purpose, would not be included in such chain. Also, there may be some uncertainty concerning whether an amount treated as a taxable dividend to DPS may be excluded from the gross incomes of the CFC partners as PTI for purposes of applying the Subpart F income definitions. Of course, because the $100 distributed to DPS was already included in the income of USP, §959(b) should apply to CFC1 and CFC2 to ensure that such amount is not included in the income of USP a second time as Subpart F income. This result should be confirmed by the new regulations. 

Furthermore, a distribution of the $100 of PTI from CFC3 to DPS and from DPS to its CFC partners should not result in taxable gain. Nevertheless, the basis rules must work correctly for this to be the result.

Section 961 provides rules for adjusting basis that correspond with the PTI rules in §959. These rules generally provide for basis adjustments in the stock of the first-tier CFC owned by the U.S. shareholder that includes the Subpart F amounts in its gross income. Section 961(a) provides that the basis of a U.S. shareholder's stock in a CFC is increased by the amount required to be included in gross income with respect to the stock. Section 961(b) provides that the basis of stock with respect to which the U.S. shareholder receives an amount that is excluded from gross income under §959(a) shall be reduced by the amount so excluded.

Accordingly, because, under the Notice, USP includes the Subpart F income of CFC3 in its gross income, the basis in the stock of CFC1 and CFC2 held by USP should correspondingly be increased. Because there is another U.S. shareholder in the chain of ownership of CFC3, i.e., DPS, the regulations should confirm this result, which would not be the result absent the rules to be provided in the new regulations treating DPS as foreign, resulting in USP including CFC3's Subpart F interest income in its gross income under §951(a).  It does not appear that DPS—the direct U.S. shareholder in CFC3—would be entitled to increase its basis in CFC3 under §961(a), because it would not have included the Subpart F income in its gross income.

Generally, a U.S. shareholder that receives a distribution of PTI from a CFC reduces its basis in the stock of the CFC by the amount of the distribution. If that occurred when CFC3 distributes PTI to DPS, the distribution might exceed basis, because there would have been no basis increase for the Subpart F inclusion. Section 961(b)(2) provides that gain is recognized to the extent an amount of PTI distributed that is excluded from gross income under §959(a) exceeds the basis in the stock or other property with respect to which it is received. For the rules to work properly, a distribution by CFC3 to DPS out of PTI should not reduce DPS' basis in the stock of CFC3. This should be the result because DPS would not have received a basis increase in the stock of CFC3 as a result of the Subpart F inclusion in the income of USP, and DPS does not exclude the PTI distribution from its gross income under §959(a). This should be the result even though CFC1 and CFC2 should exclude such PTI from their Subpart F incomes under §959(b).  The new regulations should confirm this treatment.

Distributions by DPS to CFC1 and CFC2 generally should not be subject to taxation because they are merely distributions from a partnership. Nevertheless, the basis rules must work correctly, because gain is recognized to the extent a distribution to a partner exceeds the partner's adjusted basis in its interest in the partnership.17  Section 961 does not appear to provide step-ups in the bases of the partnership interests held by CFC1 and CFC2 as a result of the inclusion of CFC3's Subpart F income in the income of USP.  On the other hand, §705 should provide a basis step-up for the $100 dividend paid by CFC3 to DPS. This result under §705 should follow from DPS's being treated as receiving a taxable dividend from CFC3, even though the PTI is not treated as gross income for purposes of applying Subpart F to CFC1 and CFC2. Again, the new regulations should confirm this result.

A distribution of the $100 of PTI by CFC1 and CFC2 to USP should be excluded from the gross income of USP under §959(a).  In addition, the bases in the stock of CFC1 and CFC2 that were increased for the Subpart F inclusion correspondingly should be reduced when USP receives the $100 distribution.

In summary, the new regulations will provide that CFC3's Subpart F income skips past DPS, a U.S. shareholder in the chain of ownership, to USP, by treating DPS as a foreign partnership for purposes of §951(a). This rule ensures that the Subpart F income will be included in the gross income of a U.S. taxpayer.  The application of §959 and §961 should be correspondingly clarified to ensure that such amounts are not again subject to U.S. taxation as they are distributed up through the chain of ownership to USP.

This commentary also will appear in the August 2010 issue of the BNA Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, Lyon, and Noren, 926 T.M., CFCs — General Overview, and Yoder and Kemm, 930 T.M., CFCs — Sections 959-965 and 1248,  and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.



1 2010-22 I.R.B. 715. See also Notice 2009-7, 2009-1 C.B. 312.

 

2 The regulations to be issued will apply to taxable years of a domestic partnership ending on or after May 14, 2010.

 

3 §951(a)(1).

 

4 §951(b).

 

 5 §958.

 

6 §§957(c), 7701(a)(30).

 

7 §7701(a)(4).

 

8 Regs. §1.958-2.

 

9 §§951(a), 958(a).

 

10 §§701, 702, 704.

 

 11 §§881, 882.

 

 12 §§952, 954. See Regs. §1.952-1(g) (classifies distributive share of partnership income for Subpart F purposes as if received directly by CFC partners); Regs. §1.702-1(a)(8)(ii).

 

13 The Notice would not treat DPS as an aggregate. Cf. Regs. §1.701-2(e), (f).

 

 14 For example, DPS would be treated as domestic for purposes of applying §956 or §1248.

 

15 §959(c).

 

16 §954(c)(1)(A).  Exceptions are provided for certain dividends received from related CFCs. §954(c)(3), (c)(6); see Regs. §1.954-1(g) (application of same country exception to distributive share of partnership income); Notice 2007-9, 2007-5 I.R.B. 401 (application of CFC look-through exception to distributive share of partnership income).

 

17 §731.