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By Lowell D. Yoder, Esq. McDermott Will & Emery LLP, Chicago, IL
The Obama Administration has proposed to significantly limit the classification of foreign entities as disregarded for U.S. tax purposes.1 This proposal is misguided.
Current law provides that most foreign entities with one owner-member may, by election, be classified as disregarded from their owners for U.S. tax purposes.2 Accordingly, such entities are treated in the same manner as a division or a branch of the owner.
Under the Obama Administration's proposal, most foreign entities would no longer be eligible to be classified as disregarded from their owner. Rather, as a general rule, foreign entities with one foreign owner would be classified as corporations for U.S. tax purposes.3
The reason given for this change is the concern that disregarded entities permit U.S. companies to shift their profits to tax havens without current income inclusion under Subpart F of the Code. It is stated that “this practice allows taxes that would otherwise be paid in the U.S. on passive income to be avoided.”
The description of the Administration's proposal contains the following example. A U.S. company invests $10 million to build a new factory in Germany. The U.S. company sets up three new corporations: A Cayman Islands holding company (“Cayman HoldCo”), which owns a new German operating company (“German OpCo”) and owns a second Cayman Islands company (“Cayman FinCo”). Cayman FinCo loans $10 million to German OpCo to build the factory (assume a 5-year term with a 6% interest rate, resulting in interest payments totaling $3 million). The interest expense on the loan is deductible in Germany but not taxable in the Cayman Islands. The example observes that “[i]n this way, income is shifted from a higher-taxed Germany to a no-taxed Cayman Islands.”
In addition, the description says that “under traditional U.S. tax law” the income shift from German OpCo to Cayman FinCo would count as passive income for the U.S. parent which would have to pay U.S. tax on it under Subpart F ($3 million × 35% = $1.05 million). If an election is made to disregard German OpCo and Cayman FinCo, the interest paid would not be currently included in the gross income of the U.S. company under Subpart F because the payment is disregarded. As a result, it is noted that “the taxpayer is able to avoid both U.S. and German taxes on its profits.”
The proposal is off the mark. The arrangements targeted do not result in the U.S. company paying less U.S. taxes on its own taxable income, i.e., there is no shifting of income from the United States to a foreign subsidiary. Rather, the proposal aims at the reduction of foreign taxes on income derived by a foreign company from operations conducted in a foreign country, which is the prerogative of the foreign country (e.g., impose a withholding tax or limit the deduction for interest).
In addition, the proposal misrepresents the activity that it targets. The description states that the income targeted is “passive” income derived by a foreign subsidiary that should be taxable currently to the U.S. shareholder under Subpart F. However, this is not an accurate classification of the income. The only income derived by the foreign group is the income derived by German OpCo from its business operations. In addition, under current law the interest paid by German OpCo out of its operating income would not be Subpart F income to Cayman FinCo if the foreign entities were instead classified as corporations.4 On the other hand, actual passive income derived by any of the foreign entities would be subject to Subpart F. For example, if German OpCo or Cayman FinCo derived interest income from investments, such income generally would be included in the U.S. parent's gross income under Subpart F regardless of whether the foreign entities were disregarded or regarded as separate corporations.
The Administration's proposal ignores the clear policy judgment of Congress. In 2006, Congress added §954(c)(6) to expressly provide that the interest received by Cayman FinCo from German OpCo paid out of its operating income is excepted from the definition of Subpart F income. The Committee Reports explain that the reason for this amendment was that prior law unduly restricted the ability of U.S.-based multinational corporations to move their active foreign earnings from one CFC to another. Congress believed that taxpayers should be given greater flexibility to move non-Subpart F earnings among CFCs organized in different countries as business needs may dictate with no additional tax burden.5
The proposal encourages structures that would result in less U.S. tax revenues. If the Obama Administration's proposal is adopted, a possible financing alternative is for German OpCo to be funded by transferring the $10 million for stock rather than for debt. In this event, German OpCo's German tax liability would be increased by the amount of the German tax rate times the forgone interest deduction (e.g., $3 million × 32% = $.96 million). Subpart F would not apply to any income under these circumstances so no U.S. tax would be incurred. Furthermore, unlike the above structure, the $3 million when repatriated to the United States would bear minimal U.S. taxes ($90,000) as a result of the additional German taxes being claimed as a foreign tax credit.
Hence, the proposal to limit classification of foreign entities as disregarded is ill-advised. Such a rule is unnecessary to subject foreign passive income to current U.S. taxation under Subpart F, discourages finance structures that result in the reduction of foreign tax (not U.S. tax), which would increase the overall tax burdens of U.S. companies while resulting in such companies paying less U.S. tax.
This commentary also will appear in the August 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 Yoder, 927 T.M., CFCs -- Foreign Personal Holding Company Income, and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.
1 White House Press Release, “Leveling the Playing Field,” 89 BNA Daily Tax Rpt. GG-3 (5/12/09); see also U.S. Treasury Department, General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals (5/11/09) (“Green Book”).
2 Regs. §301.7701-2(c)(2)(i). The regulations contain a list of foreign entities that are classified as per se corporations, typically one entity per country. Regs. §301.7701-2(b)(8).
3 An exception would be provided for entities, the owner of which is organized under the laws of the same country, and the proposal would not apply to foreign entities owned directly by a U.S. person, except in cases of U.S. tax avoidance.
4 §954(c)(6) (scheduled to expire in 2009). Somewhat surprisingly, the Obama Administration has proposed extending this “look-through” exception through 12/31/10. See p. 19 of the Green Book.
5 S. Rep. No. 108-192, at 38-39 (2004) (discussing an earlier proposed version of this legislation); H. Rep. No. 108-548, pt. 1, at 202-03 (2004) (same); see also Joint Committee on Taxation, General Explanation of the Tax Legislation Enacted in the 109th Congress, JCS-1-07 (1-17-07). See Yoder, “Subpart F Related CFC Look-Through Exception Provided in Tax Bills Passed by Senate and House,” 4 J. of Tax'n of Global Trans. 3 (Fall 2004).
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