International Aspects of the Final §1411 Regulations

By Kimberly S. Blanchard, Esq.  

Weil, Gotshal & Manges LLP, New York, NY

Proposed regulations under §1411, issued in December 2012,1 drew a fair
amount of commentary, including on the international aspects
thereof.2 Final regulations
under §1411 were issued on November 26, 2013.3 The final
regulations made a number of changes in response to comments
received. This commentary will summarize the highlights of what was
changed and will also note a few things that should have been
changed but were not.

1. The Final Regulations Retained the (g) Election

The final regulations follow the proposed regulations in turning
off the inclusion rules of §951(a) (applicable to CFCs) and
§1293(a) (applicable to PFICs that are QEFs in the hands of a U.S.
shareholder). Thus, an inclusion from a CFC as to which the U.S.
individual is an inclusion shareholder, or from a PFIC as to which
a QEF election is in effect under §1295, will not be taken into
account as net investment income (NII). Instead, actual
distributions out of previously taxed income (PTI) will be treated
as NII and taxable to the U.S. shareholder under §1411, even though
such distributions are excluded from gross income for regular
income tax purposes.

Commentators noted that the application of two opposing sets of
rules to CFC and QEF shareholders raises a number of complex
issues. The IRS rejected calls to vastly simplify the rules
applicable to CFCs and PFICs by conforming the rules of §1411 to
those in chapter 1 of the Code. Considerations of relative
simplicity and administrability were sacrificed at the altar of the
IRS's own self-interest in not seeing the rationale of the
Rodriguez v. Commissioner 4 case undercut,
even though the IRS has elsewhere exercised its authority to treat
items of income differently for purposes of chapters 1 and 2A.

The complex new regime can, however, be avoided if a U.S.
individual, trust, or estate makes an election under Regs.
§1.1411-10(g) (the "(g) election"). If the election is made, the
U.S. shareholder's NII will reflect the same inclusions taken into
account under chapter 1. The election is generally irrevocable.

2. The (g) Election May Be Made on a CFC-by-CFC,
QEF-by-QEFBasis

As originally proposed, the (g) election had to be made for each
and every CFC or QEF a shareholder had an interest in. The policy
behind that "all or nothing" rule was unclear, and the requirement
led to complications where a U.S. shareholder owned interests in
various foreign corporations through different pass-through
entities, which in many cases the shareholder would not control.
Fortunately, the IRS reconsidered. Under the final regulations, the
(g) election can be made with respect to some CFCs or QEFs but not
others.5

3. The (g) Election Can Be Made by a Pass-Through Entity on
Behalf of Its Owners

The proposed regulations made the (g) election personal to each
U.S. shareholder. As a result, if a shareholder held CFC or QEF
shares through a pass-through entity, any election would need to be
made by the shareholder rather than the entity.  This rule
created complexity in that a given pass-through entity might have
some shareholders who had made the election and others who did not.
In addition, the pass-through entity would need to provide
different tax reporting information to those who did not make the
election. 

The final regulations allow an S corporation, a domestic
partnership, or a common trust fund to make the (g) election on
behalf of all of its U.S. owners.6 This is a welcome
change. However, there is a glitch in the final regulations; there
is no apparent way in which a U.S. partner of a foreign partnership
can make the (g) election.  While the regulation specifically
allows an individual or an upper-tier pass-through entity to make a
(g) election with respect to a CFC or QEF held through a lower-tier
domestic pass-through entity, there is no rule that allows
an individual or an upper-tier pass-through entity to make such an
election in respect of shares held through a foreign partnership.
It is likely that the oversight (one hopes it is an oversight) was
caused by the drafters' focus on the fact that a QEF election, for
example, can only be made by a domestic, not a foreign, entity.

4. Double Counting Problems Solved

The proposed regulations adopted a set of inclusion rules for
§1411 purposes, but omitted to solve some double-counting problems
that had long ago been spotted and fixed under the longstanding
inclusion regimes of Subpart F and the QEF rules. For example, by
turning off the exclusion from gross income for PTI distributions,
the proposed regulations could have resulted in double taxation of
a CFC's earnings where CFC shares were sold to a U.S. individual,
trust, or estate that was subject to §1411, because the earnings of
the CFC would not be reduced by the §1248 amount taken into account
by the seller. Therefore, when the CFC was deemed to make a
distribution out of the same earnings to the buyer, the buyer could
have been subject to tax on the same earnings under the PTI model
adopted by the regulations.

The final regulations solve this double-counting problem by
adopting a rule similar to that in §959(e).7

Another example of double counting presented by the proposed
regulations arose where a seller of CFC or QEF shares had made the
(g) election but the buyer did not. Having made the (g) election,
the seller would have been taxed on NII as Subpart F inclusions
were taken into account each year during the seller's holding
period, whether or not any amounts were actually distributed. The
buyer would be taxed again on the same underlying earnings if
distributions out of the PTI were made to the buyer following the
purchase. Fortunately, the final regulations solved this problem as
well.8

5. No Clarification Regarding PFICs

The final regulations retain the rule of the proposed
regulations that "[t]o the extent an excess distribution within the
meaning of section 1291(b) constitutes a dividend within the
meaning of section 316(a), the amount is included in net investment
income… ."9 As noted in a prior
article,10  to the extent
an excess distribution is allocated to prior years in a U.S.
shareholder's holding period during which the foreign corporation
was a PFIC, the excess distribution never enters into a taxpayer's
gross income at all. Instead, an addition to tax, known as the
"deferred tax amount" is payable. Moreover, the PFIC rules operate
without regard to earnings and profits, so there would not be any
basis upon which to conclude that a particular distribution
constitutes a "dividend." It, therefore, remains unclear how the
rule of the regulations is to be applied in practice.

6. Foreign Tax Credits

Commentators on the proposed regulations noted the lack of any
foreign tax credit for foreign taxes imposed on NII.  A NYSBA
Tax Section report11 also noted
the possibility that failure to allow the credit could be a breach
of many, if not all, U.S. income tax treaties. The final
regulations continue to take the position that no foreign tax
credit is allowable with respect to items of income subject to the
§1411 tax, and refuse to engage on the treaty question.

The Preamble to the final regulations grossly misstates the
manner in which income tax treaties apply to the question of
whether a foreign tax credit must be given for the §1411 tax. 
It states as follows:If … a United States income tax treaty
contains language similar to that in paragraph 2 of Article 23
(Relief from Double Taxation) of the 2006 United States Model
Income Tax Convention, which refers to the limitations of United
States law (which include sections 27(a) and 901), then such treaty
would not provide an independent basis for a credit against the
section 1411 tax.12

The "limitations of U.S. law" that are referred to in the cited
provision are limitations imposed by existing law, which could
include later modifications thereof. Treaty Technical Explanations
published by the Treasury Department make clear that this passage
is referring to limitations such as those imposed by §904. It would
be absurd to suggest that those limitations could include §901
itself. A treaty requires each treaty partner to either provide a
foreign tax credit with respect to, or exempt, income that the
other treaty partner has the primary right to tax; the United
States is not free simply to deny any credit (or exemption) and
call that a "limitation of U.S. law"!

The IRS might have argued that because the §1411 tax is a new
tax, it is not covered by existing treaties. However, all U.S.
income tax treaties apply to income taxes now or hereafter imposed
by each country, and there is no room to argue that the §1411 tax
is not an income tax.

The essential bargain of a tax treaty is that each country cedes
to the other the primary right to tax certain income.  If the
countries did not agree to do this, there would be little point in
having tax treaties at all. Our treaty partners would be wholly
correct to object to the United States' refusal to allow a credit
for their taxes against the tax imposed under §1411.  To deny
the credit discourages investment in the other country, which
defeats the main point of a treaty. Consider the following
(simplified) case:U.S. individual A recognizes $100 of
foreign-source income, all of which is included in taxable income
under chapter 1 and in NII under §1411. A's effective rate of U.S.
income tax under chapter 1 is 35%; after taking into account §1411,
A's effective rate of U.S. tax is 38.8%. A pays $40 in foreign
income tax.

If the foreign tax is not creditable against the §1411 tax, A
will be able to utilize only $35 of the foreign tax paid as a
credit. A's total combined U.S. and foreign taxes would then be $40
plus $3.80, for a total of $43.80. Had the foreign taxes been
creditable against the §1411 tax, A's total tax liability would
have been only $40.

Note that if instead A had recognized the same amount of income
from U.S. sources only, A would have paid total taxes of only
$38.80. Thus, by investing outside of the United States, A incurs
not only the marginal $1.20 of foreign tax, but also bears an
additional U.S. tax of $3.80 attributable to the lack of any
foreign tax credit in excess of $35.

This commentary also will appear in the February 2014 issue
of the
 Tax Management International Journal.
 For more information, in the Tax Management Portfolios,
see Klasing and Francis, 918 T.M.
, Section 911 and Other
International Tax Rules Relating to U.S. Citizens and Residents,
 and in Tax Practice Series, see ¶3310, Computation of Tax
- Individuals.

 


 

  1 REG-130507-11, 77 Fed. Reg. 72612 (12/2/12). 

  2 See, e.g., Blanchard and Bower, "The
Application of §1411 to Income from CFCs and PFICs," 42
Tax Mgmt. Int'l J. 127 (3/8/13); New York State Bar
Association Tax Section, Report No. 1284, Report on the
Proposed Regulations Under Section 1411
 (5/15/13); New
York State Bar Association Tax Section, Report No. 1285, Report
on Proposed Regulations Section 1.1411-10
 (5/22/13).

  3 T.D. 9644, 78 Fed. Reg. 72394 (12/2/13). 

  4 137 T.C. 174 (2011), aff'd, 722 F.3d 306
(5th Cir. 2013). 

  5 Prop. Regs. §1.1411-10(g)(1)'s lead-in language
was deleted. 

  6 Regs. §1.1411-10(g)(3). 

  7 Regs.
§1.1411-10(c)(1)(i)(A)(2)(ii). 

  8 Regs.
§1.1411-10(c)(1)(i)(A)(2)(i). 

  9 Regs. §1.1411-10(g)(1)(ii). 

  10 See Blanchard and Bower, fn. 2,
above. 

  11 See NYSBA Report No. 1284, fn. 2,
above. 

  12 T.D. 9644 at page 11.