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Multinationals like Coca-Cola Co. and private equity firms are concerned that a provision in the new tax law could end up changing the way foreign entities that were meant to be exempted are taxed—potentially putting them in the crosshairs of new U.S. international tax rules.
And it’s unclear whether their concerns can be addressed by Treasury or whether Congress will have to step in.
The issue arises from a change in the law that will result in more foreign entities being treated as controlled foreign corporations (CFCs)—defined as foreign corporations that are more than 50 percent owned by U.S. persons—which can subject U.S. shareholders of those entities to additional U.S. tax and new reporting requirements.
Based on the conference report on the new law, it seemed Congress meant to provide an exception for some types of entities, but that language didn’t find its way into the actual statute.
On behalf of Coca-Cola, Gregory S. Nickerson, a principal at the Washington Tax & Public Policy Group, in a March letter asked the Treasury Department and the Internal Revenue Service to issue guidance consistent with Congress’s intent. The firm lobbied Treasury and both houses of Congress on a variety of specific provisions related to the new tax law, including “958(b)(4),” the repealed tax code section from which this issue arises, according to federal lobbying disclosure forms for the first quarter of 2018.
Coca-Cola’s request may not be that easy.
“The statutory language seems pretty clear on its face,” said Paul Schmidt, chair of Baker & Hostetler LLP’s National Tax Group in Washington, who has been hearing from clients on this issue. The question that has people wringing their hands is whether Treasury has the flexibility to create exceptions that don’t appear directly in the statute, said Schmidt, a former legislation counsel to the Joint Committee on Taxation.
In a June 29 email, a spokeswoman for Senate Finance Committee Chairman Orrin G. Hatch (R-Utah) said the senator believes the legislative intent is clear and a regulatory fix is appropriate. “He has encouraged the Treasury Department to issue taxpayer guidance consistent with that intent,” the email said. Others have doubts.
Steve Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center and another former legislation counsel with the JCT, said he thinks the apparent glitch requires Congress to act. However, the likelihood of a resolution being reached anytime soon seems slim, he said.
Democrats and Republicans “are at loggerheads, so a technical correction bill is unlikely in the near term,” Rosenthal said in an email. “Moreover, I think the Ds are not rushing to solve problems of multinational corporations,” he said.
Coca-Cola’s “letter continues to reflect our position,” a company spokesperson said in an emailed statement. “While we are hopeful that the issue will be addressed, we are awaiting further guidance.”
The new tax law (Pub. L. No. 115-97) repealed tax code Section 958(b)(4). As a result of that repeal, a foreign subsidiary that is owned by a foreign parent corporation that also owns a U.S. subsidiary will be treated as being owned by the U.S. company, thus making it a CFC.
This concept is known as “downward attribution” and, the way the statute is written, it applies even if the foreign and domestic subsidiaries are unrelated based on the definition of related persons in Section 954(d)(3).
U.S. shareholders only have to pay additional U.S. tax on their earnings from the foreign corporation—that’s now considered a CFC—if they own 10 percent or more of the corporation’s stock, by vote or value. However, regardless of whether they owe tax, in the majority of cases the shareholder will have to comply with new reporting requirements.
The conference report suggests that lawmakers intended to create a carve-out for unrelated parties. “The provision is not intended to cause a foreign corporation to be treated as a controlled foreign corporation with respect to a U.S. shareholder as a result of attribution of ownership under section 318(a)(3) to a U.S. person that is not a related person (within the meaning of section 954(d)(3)) to such U.S. shareholder as a result of the repeal of section 958(b)(4),” the report said.
The new downward attribution rules were meant to target “post-inversion structures” where a U.S. company inverts, “de-CFCs” by shifting some ownership in a foreign company under a common foreign parent over to the parent corporation, but still retains an interest in the foreign subsidiary—just not enough to be subject to the CFC rules, said Cory Perry, international tax senior manager in the Washington National Tax Office at Grant Thornton LLP.
However, because the relatedness component is missing in the statute, “it actually hits a lot of different transactions” and many taxpayers are unexpectedly facing, for example, the new tax on global intangible low-taxed income (GILTI), which is triggered if a taxpayer is a 10-percent-or-more U.S. shareholder of a CFC, Perry said. Under less common circumstances, taxpayers can also be subject to the one-time “transition tax” on income accumulated overseas since 1986, he said.
Perry and Schmidt said that multinationals aren’t the only ones unhappy with the new downward attribution rules and the lack of an unrelated party exception.
Under rules known as the portfolio interest exemption rules, which are used heavily by certain investment funds, interest received by a CFC from an unrelated U.S. person isn’t subject to withholding tax. However, if the interest comes from a related U.S. person, it doesn’t qualify for this benefit.
There are a number of structures that previously relied on the lack of downward attribution to reap the benefits of the portfolio interest exemption rules, Perry said.
For example, there may be a foreign investor that, through one vehicle, owns 10 percent of a partnership to invest in the U.S., and, through another vehicle, lends money into the U.S. If another investor in the partnership has a domestic corporation, because of the downward attribution rules “the partnership is deemed to own the foreign sub that’s loaning in as well as potentially a domestic corp. and so you can have a situation where you would not be able to benefit from portfolio interest exemption where you did in the past,” Perry said.
There are also structures that private equity has used in which a PE firm invests in foreign multinational groups using non-U.S. partnerships, as opposed to domestic ones, to “break CFC status,” he said.
In the past, they would invest in foreign multinational groups through offshore partnerships to avoid testing for CFC status at the partnership level, which would occur if a U.S. partnership was used and would result in most of the foreign companies in the chain being CFCs, Perry said. Instead, “you’re testing at the partner level because you look through the foreign partnership to the first U.S. person,” resulting in fewer CFCs, he said. This strategy is no longer as effective.
The American Investment Council, which represents private equity firms, in February wrote a letter to Treasury asking the department to issue regulations to provide an exception to the downward attribution rules for unrelated parties. “The congressional intent on this issue is clear—and Treasury has the regulatory authority to prevent unintended consequences,” the group’s general counsel, Jason Mulvihill, reiterated in a June 29 statement to Bloomberg Tax. “The new law was never intended to cause a foreign corporation to be treated as controlled by US persons who do not have, together with any related foreign persons, control over the foreign corporation.”
The American Institute of CPAs made a similar request in a March letter to Treasury and the IRS.
So far, the government in Notice 2018-26 has provided narrow relief under the new downward attribution rules for certain situations involving partnerships, but the main issue of an exception for unrelated parties remains unresolved.
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