By Philip D. Morrison, Esq. Deloitte Tax LLP, Washington, DC
In a commentary entitled “Should the United States Adopt a 'Managed and Controlled’ Test for Offshore Investment Funds?” (see 38 Tax Mgmt. Int'l J. 293 (May 2009)), Ken Krupsky highlights §103 of the “Stop Tax Haven Abuse Act” (S. 506, H.R.1265), introduced on March 2 in the Senate by Senator Levin and on March 3 in the House by Congressman Doggett (the “Bill” or the “Levin Bill”). Ken's focus, as his title suggests, is on offshore investment funds, one of the clear targets of the Levin Bill.1 Section 103 of the Levin Bill, however, reaches well past its stated targets of hedge funds and expatriated, formerly-U.S. companies. If enacted, it would impact every foreign multinational with a U.S. presence that may manage its day-to-day operations with little attention to national boundaries. Whether enacted soon or not, this provision likely will find support in Congress and possibly in the Administration if only because it can masquerade as a concept similar to that used by virtually all other developed countries for determining tax residence of corporations. Its differences from those other countries' concepts, however, are manifest, as are the incredible complexity and administrative burdens that will result from those differences. It demands some serious attention.
Section 103 of the Bill would create new §7701(o). New §7701(o) would provide that, subject to certain exceptions, an otherwise “foreign” corporation would be considered “domestic” if its management and control occurs, directly or indirectly, “primarily within the United States.” A domestic corporation, of course, is subject to U.S. tax on its worldwide income, including tax on a U.S. shareholder's Subpart F inclusions. Currently, of course, a corporation generally must be chartered in a U.S. state to be treated as “domestic.”
Under the Bill, whether a corporation is managed and controlled “primarily” in the U.S. is a matter for regulations. The Bill mandates that regulations provide that:
(i) the management and control of a corporation shall be treated as occurring 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
(ii) individuals who are not executive officers and senior management of the corporation (including individuals who are officers or employees of other corporations in the same chain of corporations as the corporation) shall be treated as executive officers and senior management if such individuals exercise the day-to- day responsibilities of the corporation described in clause (i).
This mandate, and its possible interpretations, are the crux of the provision for foreign-chartered corporations with U.S. operations.
It is clear from this mandate, first, that avoiding having “management and control” in the United States will not be as simple as assuring that a majority of board of directors meetings occur outside the United States. Thus, with the possible exception of the U.K. Inland Revenue's interpretation of the U.K. concept, American “management and control” will be far different than the rest of the world's “management and control” since other countries generally look to where board meetings take place.
Second, it is clear that the difference involves considerable complexity and uncertainty. How much is “substantially all” of the executive officers and senior management? Greater than 90%? Or is it some lower threshold, like greater than 50%? And how is the percentage measured? By headcount? By compensation? By importance of the work performed/decisions made in the United States vs. elsewhere? (Is a decision to make a major acquisition weightier than a decision to change a human resources policy? Should that matter? If it does, how is that different weight measured?) And what does “located primarily within the United States” mean? That the measured executive spends more than half her working days in the United States? Or that the executive is individually tax-resident in the United States? Who are the executive officers and senior management of the corporation who exercise day-to-day responsibility for making decisions involving strategic, financial, and operational policies? If decision-making is generally by consensus, do all those with input count? Or only the person with ultimate veto power, whether or not he ever exercises that power? What decisions constitute strategic, financial, and operational policy decisions and how are they distinguished from implementation and other non-policy decisions? If the decision to borrow a large sum in the corporate bond market is a financial policy decision, are the follow-on decisions regarding which investment bank to use, what terms to accept, what amount should be borrowed, how existing lenders should be approached, etc., etc., also financial policy decisions? Then there is the question as to what does it mean for management and control to occur “directly or indirectly” primarily in the United States. Does this mean that management decisions in the United States by a holding company's management can taint a subsidiary?
These difficult questions must be answered, preferably in the legislation itself, or §103 will be incapable of being administered. Even if these questions are answered clearly and comprehensively, however, their complexity reveals that the burden of recordkeeping on foreign-chartered corporations' management will be enormous and the ability of the IRS to administer this provision will be seriously in question.
The really daunting challenge, however, comes in applying the answers to all these questions to each and every foreign-chartered subsidiary (with gross assets of $50 million or more) in a foreign multinational's structure.2 Because of clause (ii) in the Bill's language quoted above, if a subsidiary has its own management, or someone other than senior management of the multinational's parent exercises day-to-day responsibility for making decisions involving strategic, financial, and operational policies of the subsidiary, then those other managers will be looked at in the management and control test with respect to the individual foreign-chartered subsidiary's classification as domestic or foreign.
Take, for example, a foreign-chartered multinational that permits its various divisions to operate with some managerial autonomy, regardless of whether a division consists of subsidiaries that are parent-sub or brother-sister-cousin. If a division is managed in the United States, each of those other subsidiaries, regardless of ownership, may be deemed to be U.S. domestic corporations. This will often be the case with respect to a foreign-chartered multinational that has grown through acquisitions. An acquired U.S. sub-group may have spun out from under the U.S. subsidiaries of their former CFCs but management of the sub-group may still be predominantly in the United States. In such a case, even though the senior management of the overall group is predominantly foreign, the sub-group's foreign-chartered members may all be considered U.S. domestic corporations. And once a foreign-chartered member of the sub-group becomes a U.S. domestic corporation, its subsidiaries will become CFCs.3 Add the facts that a foreign-chartered multinational may have hundreds of such subsidiaries and each subsidiary may operate as part of more than one division where not all of the divisions are U.S.-managed, and the compliance nightmare is evident.
Further, once a foreign-chartered corporation becomes a U.S. domestic corporation by virtue of new §7701(o), it is exceedingly difficult to ever exit, even if management and control is moved entirely outside the United States. Unlike other countries, the United States has an anti-expatriation provision, §7874, that flatly forbids the expatriation of U.S. corporations if there is adequate shareholder continuity in the expatriation transaction, except where there are substantial business activities of the corporate group in the destination country. Even if §7874 doesn't apply, there will be toll charges imposed upon the exit.
In addition to the false assertion that §103 of the Bill is like other countries' corporate tax residence tests, another misleading claim is that §103 is a familiar test used in recent U.S. tax treaties. While it is correct that a similar test is included in some of the most recent U.S. tax treaties, it is completely misleading to suggest that the test is used by taxpayers except in unusual circumstances. In recent U.S. treaties, the “management and control” test is one of two options for proving “substantial presence” in a treaty country. The other option, a stock trading test, is far clearer and far easier to satisfy. Moreover, these two options are parts of only one of four alternative tests, the satisfaction of only one of which is a necessary part of obtaining an exemption from withholding tax on dividends. Finally, the treaty management and control test applies only to a single company, the public company at the top of a multinational's structure, not to each and every subsidiary. While a complex and tough-to-administer test may be acceptable where, in the treaty context, it is one of several alternative tests to apply to obtain benefits (and even then applies only to a single corporation in the group), it is far different when such a test is the only test applicable and huge tax consequences are at stake.
Section 103 of the Bill, if not consigned to the trash bin, obviously needs a lot of work. It is also curious that, at a time when foreign-owned multinationals are responsible for a significant number of U.S. jobs, Congress would enact a provision that would make life considerably harder for them while also driving their management out of the United States. If the provision is not rejected wholesale, significant surgery should be performed on it to prevent this.
This commentary also will appear in the June 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 ¶7110, Foreign Income Taxation -- General Principles.
1 Senator Levin's press statement released upon introduction of the Bill states, with characteristic hyperbole, “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 - the folks who exercise control of the company, its assets, and investment decisions - live and work right here in the United States.” Another target named in the press statement is inverted companies--companies that have expatriated from the United States prior to the effective date of §7874.
2 Even those owned by a parent which is made a U.S. domestic corporation because of §103 and which are, therefore, subject to the Subpart F regime as CFCs can still be made into a U.S. domestic corporation if primarily U.S. managed and controlled. Such companies will not qualify for the CFC exception because they are not owned by a company that is domestic irrespective of §103. Is this intended as a back-door repeal of deferral for CFCs of U.S. subsidiaries of foreign multinationals?
3 Unless the CFC itself is primarily managed and controlled in the United States, in which case the CFC will become a U.S. domestic corporation.
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