Regulations' Anti-Abuse Rule Creates Taxpayer Windfall

By Kimberly S. Blanchard, Esq.  

Weil, Gotshal & Manges LLP, New York, NY

This is a short story about homeless income, and about how
attempts to combat natural arbitrage between different countries'
tax systems can backfire on the government.

Prior to 1990, a foreign person could create a grantor trust for
a U.S. beneficiary, such that the foreign person would be treated
as the owner of the trust. Because the foreign person would often
not be subject to U.S. tax on the income of the trust (e.g.,
because the trust earned no U.S.-source income other than perhaps
portfolio interest and exempt capital gains), substantial wealth
could be passed to a U.S. beneficiary without that beneficiary
having to report any U.S. income. In most cases, the foreign
grantor would not be taxable in his home country. The home country
would normally regard either the trust or the beneficiary as the
true owner of the income and would decline to exercise taxing
jurisdiction; few countries have rules parallel to the Code's
grantor trust rules. In such cases, the income of the trust would
be homeless in the sense that it would not be subject to tax
anywhere in the world. Section 672(f) was added to the Code in 1990
to curtail this type of planning.

Section 672(f)(4) deals with the situation where a transfer from
a foreign corporation is treated by the transferee as a gift, and
grants authority to the IRS to recharacterize the transfer as
appropriate to prevent the avoidance of the purposes of
§672(f).  To understand the purpose of §672(f)(4), one needs
to consider the U.S. tax treatment of gifts generally. As a general
rule, the recipient of a gift does not recognize taxable income.1 The donee takes a
basis in gifted property equal to the lesser of the donor's basis
therein or the property's fair market value.2 In the
absence of a step-down to fair market value, a sale of the gifted
property by the donee following receipt of the gift would normally
result in the donee's recognition of gain. U.S. tax law generally
does not treat a gratuitous transfer from any corporation, whether
foreign or domestic, as a gift,3 the theory being
that a corporation cannot have a donative intent in the same way an
individual can.4

The regulations under §672(f)(4) reflect this approach with
respect to gratuitous transfers by corporations and treat
gratuitous transfers by foreign corporations as "purported"
gifts. 5 The regulations
begin by stating that a purported gift from a foreign corporation
to a U.S. person must be included in the U.S. person's gross income
as a "distribution," unless an exception applies.6 This
rule appears to be based upon the assumption that the U.S.
recipient of the purported gift is in fact a shareholder of the
foreign corporation, or is related by blood to such a
shareholder.

However, the regulations recognize that the donee may not in
fact own any stock of the foreign corporation, even constructively,
and provide a limited exception to the rule treating the purported
gift as a distribution to the donee. Under this exception, the
purported gift is not treated as a distribution to the donee where
the actual shareholder of the foreign corporation treats and
reports the purported gift as: (1) a distribution received by him
from the foreign corporation; followed by (2) a gift by the
shareholder individually to the U.S. donee.7 To
qualify for this exception, the U.S. donee must timely file Form
3250 and must establish to the IRS' satisfaction that the
shareholder in fact treated (and reported, if applicable) the
transfer as a distribution to him from the foreign corporation for
the purposes of his own country's tax laws.8

It is likely that the drafter of these regulations assumed that
the tax laws of the shareholder's country of residence operated in
a manner similar to those of the United States. In such a case, the
shareholder's country of residence would impose a tax on the deemed
receipt of a distribution (dividend) from the corporation. 
Moreover, if the shareholder's country of residence imposed a gift
tax, the second deemed step might result in a gift tax payable.
However, the U.S. tax regulations do not require that the
distribution or gift in fact be taxable in the individual's country
of residence, only that it be treated and, if applicable, reported
as such. If the donor's country imposes no tax on the distribution
or the gift (either because it does not follow the U.S. fiction or
because it imposes no tax under these circumstances), it is
sufficient that it be treated (and reported, if applicable) to that
country as a distribution.

The regulations' characterization of the "purported gift" as a
distribution followed by a gift will result in the U.S. donee
taking a tax basis in the gifted property equal to its fair market
value (the donor shareholder's basis), which in many cases will
exceed the corporation's pre-distribution basis in such property.9 This is an
advantageous result, and could prove especially beneficial if the
foreign shareholder is not subject to tax on either the deemed
distribution or the deemed gift in his home country.

One hates to look a gift horse in the mouth, but could the IRS
possibly have intended to give a second gift to the U.S. donee of
an untaxed stepped-up basis in gifted property? It is highly
unlikely that the donor shareholder's home country would give
effect to the regulations' two-step recharacterization of a gift by
a foreign corporation. Moreover, the foreign corporation and the
donor shareholder may reside in two different countries. Consider
the following examples. In each of the examples, Mr. A, a bona fide
resident of Country X, owns 100% of the stock of foreign
corporation B, incorporated and resident in Country Y. Mr. A wishes
to make a gift of property owned by B to U.S. donee C. He causes B
to transfer the property to C for no consideration.

Example 1. Country X imposes no income or gift taxes on
individuals. Country Y imposes no tax on distributions. Therefore,
even if A "treats and reports" the transfer as a distribution
followed by a gift, no tax will be paid by anyone anywhere, and C
will take a stepped-up basis in the gifted property.

Example 2. Country X imposes a tax on dividends, but
does not treat a gift by a foreign corporation as a deemed
dividend. Rather, it respects gifts made by corporations.  A
attempts to report the transfer as a deemed distribution on his
Country X tax return, but Country X rejects that treatment; Country
X is under no obligation to follow the U.S. deemed distribution
characterization and would simply not respect it. Same result as
Example 1

Example 3. Country X imposes a gift tax on an
individual shareholder who causes his controlled corporation to
make a gift, but does not treat the gift as a deemed distribution
to the shareholder. If A attempts to "treat and report" the
transfer as a deemed distribution to him, Country X will ignore
that characterization. A will be liable to pay gift tax, but C will
still take a stepped-up basis in the gifted property.

Example 4. A "treats and reports" the transfer as a
distribution followed by a gift.  Country X simply treats the
gift as a deemed distribution from B to A, but imposes no tax on
the distribution. Same result as in Examples 1 and
2.

The moral of this short story? Be careful what you wish for.
Cross-border arbitrage cannot be "solved" by unilateral
recharacterizations, because such recharacterizations are not
binding on other countries. And even if they were, there is no
guarantee that another country will impose tax in cases where the
United States would do so. If the net result is an unasked for
step-up or other tax benefit, the IRS might have been better off
not even trying to force the issue.

This commentary also will appear in the Mach 2014 issue of
the
 Tax Management International Journal. For more
information, in the Tax Management Portfolios, see Danforth and
Zaritsky, 819 T.M.
, Grantor Trusts: Income Taxation Under
Subpart E, Zaritsky & Rosen, 854 T.M., U.S. Taxation
of Foreign Estates, Trusts and Beneficiaries, and Bissell, 903
T.M.
, Tax Planning for Portfolio Investment into the United
States by Foreign Individuals, and in Tax Practice Series, see
¶6120, Estate and Trust Income Taxation - General Rules.

 


 

  1 §102(a). 

  2 §1015(a). 

  3 Commissioner v. Duberstein, 80 S. Ct.
1190 (1960). 

  4 An exception to this rule applies to charitable
gifts. See §170(a)(2). 

  5 Section 6039F requires a U.S. person to report
gifts from a foreign person if the gifts exceed certain threshold
amounts. A U.S. person must report gratuitous transfers from a
foreign corporation (purported gifts) if the aggregate value of the
purported gifts from that corporation exceeds $15,102 during the
2013 taxable year. Rev. Proc. 2012-41, 2012-45 I.R.B. 539,
§3.23. 

  6 Regs. §1.672(f)-4(a)(2). If a U.S. person
receives a purported gift from a foreign corporation, the U.S.
donee must include the purported gift in gross income "as if it
were a distribution from the foreign corporation." Regs.
§1.672(f)-4(a)(2).  

  7 Regs. §1.672(f)-4(b)(1)(ii). 

  8 Regs. §1.672(f)-4(g), Ex. (1)

  9 §§301(d), 1015(a).