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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
Section 892 provides an exemption from U.S. income tax for income realized by a foreign government from stocks and securities. However, the exemption does not extend to income derived by or from a "controlled commercial entity" (a "CCE") or from the disposition of an interest in a CCE.1 A CCE is an entity engaged in commercial activities anywhere in the world, if the foreign government holds, directly or indirectly: (1) 50% or more of the total interests in such entity by vote or by value; or (2) "any other interest in such entity which provides the foreign government with effective control of such entity."2
The regulations issued under §892 modify the language immediately above by adding the word "practical," such that it is "effective practical control" of a commercial entity that makes it a CCE under the second prong of the control definition.3 Reg. §1.892-5T(c)(2) fleshes out the term effective practical control (hereafter, "EPC") in the following few sentences:
An entity engaged in commercial activity may be treated as a controlled commercial entity if a foreign government holds sufficient interests in such entity to give it "effective practical control" over the entity. Effective practical control may be achieved through a minority interest which is sufficiently large to achieve effective control, or through creditor, contractual, or regulatory relationships which, together with ownership interests held by the foreign government, achieve effective control. For example, an entity engaged in commercial activity may be treated as a controlled commercial entity if a foreign government, in addition to holding a small minority interest (by value or voting power), is also a substantial creditor of the entity or controls a strategic natural resource which such entity uses in the conduct of its trade or business, giving the foreign government effective practical control over the entity.
Apart from this regulation, there is little guidance on how to determine whether a foreign government has EPC over an entity. The legislative history to §892 provides no clues as to why Congress adopted an effective control test, and the Preamble to the regulations provides no insight into why the regulations added the word "practical" to it. The purpose of this commentary is to explore the contours of what little guidance, including by analogy, exists.
It is evident from the drafting of the statute and the regulations that EPC is a test that applies where the foreign government owns less than 50% of the interests in the entity, both by value and by nominal voting power. If the 50% test is met, there is no reason to enquire into the existence of EPC, because the 50% test and the EPC test are disjunctive. This is why the regulation refers to minority interests. The ordinary meaning of the word "control" would usually imply that the holder of control had the power to cause the controlled entity to take or refrain from taking action, in turn requiring more than 50% "tie-breaker" power. But EPC is looking at something different from this traditional type of control. What it seems to be looking at is operational control.4
The term EPC appears to have been taken from guidelines that were used to determine whether an outbound transfer of property was made with a principal purpose to avoid tax and thus was subject to tax under the pre-1984 version of §367(a). Prior to 1984, §367(a) applied to an outbound transfer unless a ruling was obtained from the IRS that no such principal purpose existed. The IRS published guidelines for requesting rulings under §367(a) in Rev. Proc. 68-23, 1968-1 C.B. 821. Section 3.03(1)(d) of the guidelines provided that a favorable ruling would ordinarily be issued where, following the transfer of stock of a U.S. corporation to a foreign one, shareholders of the acquired U.S. corporation did not own more than 50% of the stock of the foreign acquiring corporation.5 The reason that this presumption was made was that if the shareholders of the U.S. corporation could not control what the foreign corporation did, then they did not transfer the stock with a principal purpose of avoiding U.S. tax.
In PLR 8707006, issued on July 1984 nearly three years after a §367(a) ruling was requested, the shareholders of the U.S. target in fact owned just under 50% of the stock of the foreign acquiror, "FC."6 However, in discussing the more-than-50% test, the ruling referred to EPC. In that ruling, all of the stock of the U.S. target had been owned by A, a single individual. The facts suggested that A had business connections with the principals of FC, which was a publicly traded corporation that was in a similar line of business to that conducted by A through the U.S. target, and that A had prevailed upon FC to acquire the U.S. target for stock through a triangular reorganization involving a merger into a newly formed U.S. subsidiary of FC. A ended up owning 43.2% of FC's voting stock; the next largest shareholder owned only 8%. He was also the president and treasurer of FC, and one of its three directors.7
A argued that these facts did not put him in a position to control FC. He pointed out that his ownership stake had been diluted to 35.5% by a subsequent public offering, and that, under the relevant foreign law, any sale by FC of the stock of the acquired U.S. corporation would require a vote of 75% of FC's shareholders. He pointed out that, as one of three directors, he was not in a position to control the board, given that the applicable foreign law held directors to the same standard of fiduciary duty applicable under the law of U.S. states. Finally, A pointed out that a sale by FC of the shares of the acquired U.S. company would be subject to tax under FIRPTA.8
Despite these arguments, the IRS concluded that "it is inescapable that A yields great influence and control over FC." Here, the IRS was taking the view that "great influence," presumably over operations, is sufficient to find control even absent the ownership of more than 50% of voting power. There was no other individual who had the principal role that A had; he was, in effect, first among unequals. The IRS stated that because the foreign corporation was publicly traded, "a much smaller amount of stock is needed to achieve effective or practical control" of that corporation. It found that A had unique knowledge and expertise in the business conducted by FC. The PLR ruled that A had EPC "which places him in the position of being able to cause FC to dispose of the stock of" the U.S. target and to "direct the day-to-day activities" of FC.
Regardless of what one thinks of the conclusion reached in PLR 8707006, it serves as a valuable source of IRS thinking on the subject of EPC.9 The PLR is a good illustration of the rule in Reg. §1.892-5T(c)(2) that a "minority interest which is sufficiently large to achieve effective control" may give rise to EPC, at least where other factors are present. Because A owned a large block of stock and no other person owned nearly as much, the issue of EPC was at least presented. When combined with A's status as president, treasurer, and a director, as well as his being uniquely familiar with the business of the combined corporations, we have here much more than the typical minority shareholder. Probably the most telling factor in the PLR was the fact that A was the sole shareholder of the target and seems to have engineered the combination.
A's arguments against his having EPC were based on formal voting power. The PLR stands for the proposition that a person who lacks the legal ability to control the vote or even to break a tie may still be in a position to have EPC over what a corporation does.
The distinction between EPC and the ownership of nominal voting shares seems to have much in common with the distinction between de facto or actual control and de jure or legal control. A number of court decisions have found a foreign corporation to be a controlled foreign corporation within the meaning of §957 based on actual control, even where U.S. shareholders did not own the requisite more than 50% of the voting shares. These cases are based on findings that one or more U.S. persons exercised de facto control over the foreign corporation, for example, where there was an arrangement by U.S. shareholders to deflect control by having the foreign corporation issue voting preferred stock with an attractive coupon to a number of malleable foreign persons.10 These cases are essentially anti-abuse cases.
Former regulations and case law under §482 have adopted an expansive approach to control that appears very similar to the language in the §892 regulations. These precedents look to "actual, practical control rather than any particular percentage of stock ownership."11 The regulations defined "control" as "any kind of control, direct or indirect, whether legally enforceable, and however exercisable or exercised. It is the reality of the control which is decisive, not its form or the mode of its exercise."12
Another analogy can be found in the Code's rules applicable to private foundations. The concept of control, and the misuse thereof for noncharitable purposes, is integral to many of the excise taxes imposed on private foundations. Section 4943, relating to the excise tax on private foundations having excess business holdings, contains an exception from the tax where unrelated persons hold "effective control" over the owned business.13 The regulations under that section define the term "effective control" as "the possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of a business enterprise, whether through the ownership or voting stock, the use of voting trusts, or contractual arrangements or otherwise."14 In this context, it is particularly appropriate that the concept of control not be tied to voting control, given the fact that private foundations do not issue stock. What the rules are looking to, as in the case of EPC, is operational control.
EPC is entirely distinct from the concept of control in substance as set forth in the case of Alumax.15 If a foreign government were found to have veto rights over decisions normally left to a majority of the directors, the Alumax doctrine would treat that foreign government as owning exactly 50% of the voting power, such that the corporation would be a controlled corporation under the first prong of the CCE definition, without the need to inquire into EPC.16 Whereas Alumax is concerned with whether a shareholder in substance owns a particular percentage of voting control, EPC is about operational control. Unfortunately, the exact contours of EPC remain unclear.
This commentary also will appear in the May 2015 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Nikravesh, Maloney, and Dick, 913 T.M., U.S. Income Taxation of Foreign Governments, International Organizations, Central Banks, and Their Employees, and in Tax Practice Series, see ¶7120, Foreign Persons — Gross Basis Taxation.
Copyright©2015 by The Bureau of National Affairs, Inc.
8 The PLR rejected the FIRPTA argument rather flippantly, suggesting that the FIRPTA taint could be avoided by altering the mix of the corporation's assets after the five-year look-back under §897(c)(1)(A)(ii) had expired.
9 Other private letter rulings discussing the 50% rule of the guidelines and EPC involve similar facts. See, e.g., PLR 8441021 (finding EPC where an individual shareholder of U.S. target and his wife, who were separated, owned in the aggregate 60.6% of the stock of foreign acquiring, and he was Chairman of the Board; this is more of a constructive ownership ruling than an EPC ruling, notwithstanding the words used); PLR 8121093 (finding EPC where the former shareholders of the U.S. target held more than 50% of the stock of the foreign acquiring corporation, even though U.S. shareholders of the target held less than 50%). Pitcher v. Commissioner, 84 T.C. 85 (1985), may involve the same taxpayer that was denied a favorable ruling in PLR 8121093. The court mentioned the IRS' argument that the taxpayers had EPC even though they owned less than 50% of the foreign corporation. However, the court declined to address the issue, finding that there was no principal purpose to avoid tax.
10 Koehring Co. v. United States, 583 F.2d 313 (7th Cir. 1978); Estate of Weiskopf v. Commissioner, 64 T.C. 78 (1975), aff'd. per curiam without pub. op., 538 F.2d 317 (2d Cir. 1976); Kraus v. Commissioner, 59 T.C. 681 (1973), aff'd, 490 F.2d 898 (2d Cir. 1974); Garlock Inc. v. Commissioner, 58 T.C. 423 (1972), aff'd, 489 F.2d 197 (2d Cir. 1973).
16 In Alumax, a U.S. shareholder nominally held 80% of the number of voting shares. However, under a shareholders' agreement, a majority of each class of stock had to approve matters traditionally reserved to the board of directors. In addition, the parties agreed to a mandatory dividend provision. The court found that the director and stockholder class voting requirements with respect to the restricted matters caused each of the two classes of Alumax stock to have 50% of the voting power on any such matter. The court noted that "[m]any of these matters lie at the core of the board's authority to run a corporation's business." The court also found that the mandatory dividend provision effectively voided the board's power to determine whether or not to declare and pay dividends, noting that the dividend policy "robbed the Alumax board of some customary discretion."
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