2014 University of Chicago Federal Tax Conference Chicago November 7 and 8, 2014 International Issues Inherent in Subchapter K 1
Agenda Introduction A Detour into Subpart F Brown Group Rev. Rul. 91-32 Section 956 2
Introduction 3
The Premise Common Point of View: A partnership should be treated as an aggregate of its partners for purposes of applying the international provisions. However, such an approach requires partners to have specific knowledge of the partnership (and vice-versa), which is often very difficult to apply in practice. In addition, published guidance has been a mix of aggregate and entity, piecemeal, and result driven. As a result, we have a set of uncoordinated rules that provide limited, if any, guiding principles and often fail to address partner-partnership transactions. Question: Does this make any sense? 4
Through the Looking Glass Suspension of Disbelief: A partnership is an entity that recognizes and reports income. Therefore, we should respect it as such and should only deviate from entity treatment when: (i) there is a specific reason to do so AND (ii) the result cannot be achieved through a different mechanism. This allows us to: o o o o Respect legal relationships; Give meaning to partner-partnership transactions; Coordinate the Subpart F rules with the FTC basketing provisions; AND Allow minority partners to engage in transactions without the need for specific knowledge of the partnership s underlying assets and activities. 5
Further Consideration U.S. Classification Parent Basic U.S. Treatment: Characterize FP s Income by reference to Corp 1 s and Corp 2 s Attributes. Corp 1 (X) Corp 2 (X) Treat gain on the sale of FP as gain from the sale of the underlying assets. Treat assets held by FP as held by Corp 1 and Corp 2. Basic Problem: FP (Y) Sub (X) For local law purposes taxing what is a corporation as a flow-through, and for U.S. tax purposes taxing what is a flow-through as a corporation. Does this make sense? Is this really a problem with checkthe-box? 6
Vocabulary 7
Vocabulary Entity Partnership viewed as an entity separately taxable from its owners. Aggregate Partners are viewed as co-owners of the underlying partnership property. All transactions between and among the partnership and third parties are viewed as occurring between the partners and the third parties. Transactions between a partner and the partnership are either: (i) disregarded or (ii) disregarded in part. Conduit/Pass-Through The taxable income derived by the partnership is characterized at the level of the partnership and flows through to the partners. Attribution Partners are treated as conducting the activities undertaken by the partnership. 8
Detour into Subpart F 9
CFCs Income Inclusion Rule If a foreign corporation is a controlled foreign corporation ( CFC ) for an uninterrupted period of 30 days or more during any taxable year, each person who is a U.S. shareholder, as defined in Section 951(b), and who owns stock in such corporation on the last day in such year in which the corporation is a CFC, must include in its gross income the shareholder s pro rata share of the CFC s Subpart F income. A U.S. shareholder is a U.S. person, as defined in Section 7701(a)(30), that owns, (within the meaning of Section 958(a) or (b)), 10 percent or more of the voting stock of a foreign corporation. Under Section 7701(a)(30), a U.S. person includes residents or citizens of the U.S. or domestic partnerships or corporations. USCo, a domestic corporation, is a U.S. person. 10
Foreign Personal Holding Company Income Includes: Dividends Interest Rents Royalties Excess of gain over loss from: o Sale of stock, o Debt instruments, o Less-than-25 percent partnership interests, o Property that does not give rise to any income Exceptions: Look through from related CFC (Section 954(c)(6)) Same country exception (dividend or interest from related CFC organized in same country as recipient and meeting certain other tests) (Section 954(c)(3)(A)(i)) Qualified "banking or financing income" of an eligible CFC (Section 954(h)) Active rents and royalties from unrelated persons (Section 954(c)(2)(A)) Look-through for sale of partnership interest where CFC owns at least 25 percent of the partnership (Section 954(c)(4)) 11
Foreign Base Company Sales Income FBCSI Includes: Subject to various exceptions, Foreign Base Company Sales Income under Section 954(d) is: o o o o Income derived in connection with the purchase of personal property from a related person and its sale to any person; Income derived from the sale of personal property to any person on behalf of a related person; Income derived from the purchase of personal property from any person and its sale to a related person; OR Income derived from the purchase of personal property from any person on behalf of a related person. Sales income will not constitute FBCSI if: The property is manufactured (by anyone) in the CFC's country of organization, OR The property is sold for use in the CFC's country of organization, OR The property is manufactured or produced by the CFC. EVEN if the property is purchased from, or sold to, a related person. 12
U.S. versus Foreign Partnership Foreign Individuals Foreign Individuals Pship (US) Pship (X) FP FP FP is a CFC FP is a NOT a CFC 13
Subchapter K Anti-Abuse Rule Treasury Reg. 1.701-2 contains broadly applicable anti-abuse provisions aimed at curtailing perceived abuse of the rules in Subchapter K including abuse of the entity concept of partnerships. Where the Service determines the entity concept of partnerships is being abused, it is allowed to treat the partnership as an aggregate of its partners to carry out the purpose of any provision of the Code. The sole exception to this rule is where (1) a provision of the Code prescribes treatment of a partnership as an entity, in whole and in part, and (2) the treatment and ultimate tax results, taking into account all facts and circumstances, are clearly contemplated by the provision. Treas. Reg. 1.701-2(f), ex. 3 14
Brown Group and Subpart F 15
Brown Group, Inc. v. Comm r Facts Brown (U.S.) Brown Cayman formed a partnership, Brinco, with two individuals, which acted as the Brown Group s purchasing agent in Brazil. Brown Group paid Brinco a 10 percent commission for the sourcing of Brazilian footwear. Brown (Cayman) Brinco Unrelated Issue Whether the income derived by Brinco and taken into account by Brown Cayman was FBCSI and in particular whether Brinco (the entity deriving the commission income) was a related party to either Brown Cayman or Brown Group. Related Person Commission With respect to a CFC, a related person is: Brazil o An individual, partnership, trust or estate which controls the CFC; o A corporation that controls, or is controlled by, the CFC; OR o A corporation which is controlled by the same person(s) which control the CFC. 16
Brown Group, Inc. v. Comm r Analysis: Brown (U.S.) Brown (Cayman) Unrelated Eighth Circuit held that the income derived by Brinco should not be included in the definition of FBCSI because: (i) the income should be characterized at the partnership level and the income should retain its character when distributed to the individual partners and (ii) Brinco earned the income from an unrelated person. Specifically, the court held: Commission Brinco Brazil Although the holding may result in a tax windfall to the Brown Group due to the particularized definition of related person under the pre-1987 version of Section 954(d)(3) of the Internal Revenue Code, such a tax loophole is not ours to close but rather must be closed or cured by Congress Indeed, Congress has done just that. It close this loophole the following year, in 1987, when it amended Section 954(d)(3) to broaden the definition of related person to include not only partnerships that control CFCs, but also those that are controlled by CFCs or their parents. 17
Brown Group Regulations 18
Brown Group Regulations Generally, the rules of Subpart F apply at the CFC partner level as if the income were earned directly. Treas. Reg. 1.952-1(g) Country of incorporation determinations based on country of CFC incorporation Related party determinations based on CFC/partner relationship to other parties Activities and property to be taken into account at partner level for exceptions generally consider only the activities and property of the partnership 19
Section 954(c) Partnership Income Section 954(c)(6): U.S. Parent Payments received by partnership are treated as received or accrued by CFC2 and CFC3 for purposes of Section 954(c)(6). CFC1 (X) CFC2 (X) CFC3 (Y) Therefore, look through rule of Section 954(c)(6) is applicable to CFC2 and CFC3. Interest, rents, or royalties 60% 40% FP (X) Section 954(c)(3): Same Country Exception of Section 954(c)(3) could also apply to CFC2, assuming other requirements are met (including the substantial assets test). 20
Section 954(c) Partnership Expense Section 954(c)(6): CFC1 (X) Interest, rents, or royalties U.S. Parent CFC2 (X) FP (X) CFC3 (Y) 60% 40% Interest, rents or royalties treated as paid by CFC2 and CFC3 (related to CFC1) for Section 954(c)(6) purposes. Therefore, look through rule of Section 954(c)(6) is again applicable to payments made to CFC1. Section 954(c)(3): Same Country Exception of Section 954(c)(3) could also apply to CFC1, to the extent the payments are attributable to CFC2, and assuming the substantial assets test is met. How do we treat the interest in FP for purposes of the substantial assets test? o o o Treas. Reg. 1.954-2(b)(4)(x) allows a CFC to look through stock of a subsidiary in determining whether a CFC s assets are located in its country of organization. What about partnership interests? Note Section 1297(c). 21
Section 904 Basket CFC1 (X) Interest, rents, or royalties U.S. Parent CFC2 (X) FP (X) CFC3 (Y) 60% 40% Sections 904(d)(3) and 954(c) each provide characterization rules for determining the FTC basket of certain payments, and whether payments constitute Subpart F income, respectively. Generally, regulations under Section 904 apply an entity approach with respect to partnerships. In contrast, Section 954(c) applies an aggregate approach. The difference in approaches can lead to mismatches between the basket of income earned and the amount which would be considered Subpart F income. 22
Section 904 Basket CFC2: U.S. Parent $250 General Basket Non-Subpart F Income CFC3: CFC1 (X) $150 Interest Expense CFC2 (X) FP (X) CFC3 (Y) 60% 40% FP $250 General Basket Non-Subpart F Income $60 Passive FPHCI $120 General Basket Non Subpart F Income $30 Passive FPCHI $150 Interest Expense 23
Computation of FPHCI: Gross Income Computational Issues CFC2 $250 General Basket Non- Subpart F $72 Non-Subpart F from FP $18 Passive FPHCI from FP CFC3 $250 General Basket Non- Subpart F $60 Passive FPHCI $48 Non-Subpart F from FP $12 Passive FPHCI from FP Expense $90 Interest from FP $60 Interest from FP FPHCI to CFC3 $18 FPHCI ( Passive First ) $60 FPHCI ( Passive First ) Non-FPHCI to CFC3 $72 Non-FPHCI $0 Computation of Basket: Gross Income FP $120 Non-Subpart F $30 Passive FPHCI Expense $150 Passive to CFC3 $30 General Limitation to CFC3 $120 24
Partnership Expense: Sections 904 and 954 U.S. Parent Sections 904(d)(3) and 954(c)(6) each provide look-through rules for determining the FTC basket of certain payments, and whether payments constitute Subpart F income, respectively. CFC1 CFC2 Generally, regulations under Section 904 apply an entity approach with respect to partnerships. In contrast, Notice 2007-9 applies an aggregate approach. Interest 40% 60% FP The difference in approaches can lead to mismatches between the basket of income earned and the amount which would be considered Subpart F income. In addition, uncertainty arises in the aggregate approach under Notice 2007-9 when payments are made by a partnership to a CFC partner. In the current example, CFC1 is treated as paying 40 percent of the interest to itself! 25
Application to Subpart F Sales Income U.S. Parent CFC Sales FP Mfg. Ops. Unrelated Assume FP manufactures products and sells them to CFC and U.S. Parent for resale. FBCSI generally results to CFC under Treas. Reg. 1.954-3 if: Product is purchased from or sold to a related party of CFC; Product is not manufactured by CFC (or by third party in country of CFC incorporation); and Product is sold for use or consumption outside country of CFC incorporation. Application to FP Under Treas. Reg. 1.954-3(a)(6): Sales (or purchases) by FP are determined to be to a related person based on CFC, not FP, relationship. FP treated as manufacturer based only on FP activities; separate activities of CFC are not taken into account. To determine whether the branch rule under Section 954(d)(2) applies, seemingly an aggregate approach is taken. See PLR201002024. 26
Brown Group FBCSI U.S. Parent 2. Sale to Customers Income earned by CFC is generally FBCSI since CFC is treated as purchasing property from a related party (FP) and selling to unrelated persons. CFC 1. Sale to CFC FP Unrelated For purposes of determining whether the manufacturing exception to FBCSI applies, it is unclear whether CFC will be treated as conducting the manufacturing activities conducted by FP. See Treas. Reg. 1.863-3(g) and Treas. Reg. 1.954-3(a)(6)(i). Section 954(d)(2)? Mfg. Ops. 27
Brown Group Revisited 28
Brown Group Facts Revisited Brown (U.S.) Brown (Cayman) Commission Brinco Sourcing Ops Unrelated If in Brown Group, Brinco were treated as an entity... Under Section 702(b), the character of any item of income included in a partner s distributive share is determined as if the item were earned directly by the partnership. Given the inclusion of a partnership as a related party under Section 954(d)(3), Brown would be treated as a related party with respect to Brinco. Brown Cayman s distributive share of related party commissions would retain its character and constitute Subpart F income. 29
Brown Group Revisited FBCSI (Branch Rule) U.S. Parent 2. Sale to Customers If FP were treated as an entity... CFC s distributive share of income from FP would qualify for the manufacturing exception. CFC (High Tax) 1. Sale to CFC Unrelated FP is a related party with respect to CFC, such that the purchase by CFC, followed by its sale to customers, would constitute FBCSI to CFC. 55% FP 45% High Tax Mfg. 30
Brown Group Revisited FBCSI (Branch Rule 2) U.S. Parent 2. Sale to Customers If FP were treated as an entity... CFC s distributive share of income from FP would qualify for the manufacturing exception. CFC (Low Tax) 1. Sale to CFC Unrelated FP is NOT related party with respect to CFC, such that the purchase by CFC, followed by its sale to customers, would NOT constitute FBCSI to CFC. 35% FP 65% High Tax Mfg. 31
Brown Group Regulations Revisited Interest If FP were an entity... U.S. Parent Same Country Exception of Section 954(c)(3) could also apply to CFC Sub, assuming the substantial assets test is met. CFC (X) FP (X) Unrelated If FP were an entity, whether the related party payor is organized in the same jurisdiction of the payee and whether the substantial assets test is met would be applied at the level of FP. CFC Sub (X) Loan Interest 32
Brown Group Regulations Revisited FPHCI (Interest) If FP were treated as an entity... U.S. Parent For Section 904(d)(3) look-through, the entity approach would still apply. CFC1 (X) CFC2 (X) CFC3 (Y) If an entity approach would apply with respect to Section 954(c)(6) look through, passive income and FPHCI would be congruous. Interest FP (X) If Section 954(c)(6) did not apply, whether FP s interest payment would meet the same country exception would be tested at the level of FP. 33
Section 904 Basket CFC2: U.S. Parent $250 General Basket Non-Subpart F Income CFC3: CFC1 (X) CFC2 (X) CFC3 (Y) $250 General Basket Non Subpart F Income $60 Passive FPHCI $120 Interest Expense 60% 40% FP (Z) FP: $120 General Basket Non Subpart F Income $30 Passive FPCHI $150 Interest Expense 34
Computation of FPHCI: Computational Issues Gross Income FP $120 Non-Subpart F $30 Passive FPHCI Expense $150 FPHCI to CFC3 $30 Non-FPHCI to CFC3 $120 Computation of Basket: Gross Income FP $120 Non-Subpart F $30 Passive FPHCI Expense $150 Passive to CFC3 $30 General Limitation to CFC3 $120 35
Revenue Ruling 91-32 36
Revenue Ruling 91-32 Facts: FMV = $475 Basis = $375 FP1 Sale for $100 gain 25% 75% PRS1 Assets Unrelated FP1, a nonresident alien individual, owns an interest in PRS1, a partnership. Some of PRS1 s assets are used or held for use in a U.S. trade or business, but PRS1 owns no USRPI. FP1 sells PRS1 and recognizes $100 of gain. Issue: Assets Value Basis Cash $300,000 $300,000 Non-U.S. Real Property 1,000,000 500,000 Non-U.S. Machinery 100,000 500,000 ECI Property 500,000 200,000 Total: $1,900,000 $1,500,000 Whether the gain recognized by FP1 on its sale of PRS1 is subject to tax in the U.S. as income effectively connected with a U.S. trade or business (ECI). 37
Revenue Ruling 91-32 FMV = $475 Basis = $375 FP1 Sale for $100 gain 25% 75% PRS1 Assets Unrelated Assets Value Basis Cash $300,000 $300,000 Non-U.S. Real Property 1,000,000 500,000 Non-U.S. Machinery 100,000 500,000 ECI Property 500,000 200,000 Total: $1,900,000 $1,500,000 Analysis: Under Section 875(1), FP1 is deemed to be engaged in a U.S. trade or business by virtue of PRS1 being engaged in a U.S. trade or business. Gain recognized by FP1 is capital gain pursuant to Section 741. Gain recognized on sale of PRS1 is attributable to the U.S. office or fixed place of business of PRS1 and is thus both U.S. source and ECI, to the extent attributable to ECI property. 38
Revenue Ruling 91-32 FP1 Unrelated Common Criticisms: Gain is not U.S. source FMV = $475 Basis = $375 25% 75% PRS1 Even if U.S. source, gain is not ECI No collection mechanism Sale for $100 gain Assets Assets Value Basis Cash $300,000 $300,000 Non-U.S. Real Property 1,000,000 500,000 Non-U.S. Machinery 100,000 500,000 ECI Property 500,000 200,000 Total: $1,900,000 $1,500,000 39
RR 91-32 Alternative Approach Alternative to RR 91-32: Adopt an entity approach. FP1 PRS1 Unrelated Apply FIRPTA-type rule requiring net-basis tax and withholding if sufficient percentage of PRS1 assets are used in a U.S. trade or business. Sale for $100 gain See e.g., H.R. 96-1167 (1980) (applying FIRPTA to RPHOs, which included partnerships). U.S. ToB Consider exception for de minimis FP1 ownership in PRS1. Deny Section 743 basis step-up to purchaser of a partnership interest from a foreign or tax-exempt seller (as was proposed H.R. 2014). 40
Section 956 41
Section 956 In General Inclusions under Section 951(a)(1)(B) CFC s average adjusted basis in U.S. property (average of the 4 quarter-ends) less prior Section 956 PTI, or CFC's "applicable earnings (current and accumulated earnings less current year dividends and less prior Section 956 PTI). Section 956 defines U.S. Property to include: tangible property located in the United States; stock of its U.S. shareholder or a domestic corporation which is 25 percent or more owned or treated as being owned by the CFC s U.S. shareholder after the acquisition; an obligation of a United States person; or any right to the use in the United States of o o o o a patent or copyright, an invention, model, or design (whether or not patented), a secret formula or process, or any other similar right, which is acquired or developed by the controlled foreign corporation for use in the United States. 42
Revenue Ruling 90-112 Facts: P (U.S.) S (Foreign) Unrelated (Foreign) S, a CFC, owned a 25 percent interest in PRS, a partnership. The remaining 75 percent of PRS was owned by unrelated parties. PRS assets included U.S. real estate which constitutes U.S. property under Section 956. Ruling: FMV = 50 Basis = 10 PRS 25% 75% U.S. Real Estate FMV = 200 Basis = 80 The U.S. real estate owned by PRS is U.S. property treated as owned by S for purposes of Section 956. The amount which constitutes U.S. property is calculated based on the adjusted basis of the U.S. property in the hands of the partnership, limited by the adjusted basis that S has in its PRS partnership interest. 43
Treas. Reg. 1.956-2(a)(3) U.S. Parent Here the U.S. partnership interest should not be Section 956 property. CFC1 CFC2 However, Treas. Reg. 1.956-2(a)(3) provides that if a CFC is a partner in a partnership that owns U.S. property, the CFC will be treated as holding an interest in the property equal to its interest in the partnership and such interest will be treated as an interest in United States property. USP Thus, Rev. Rul. 90-112 and Treas. Reg. 1.956-2(a)(3) generally adopt aggregate type principles for Section 956. U.S. Property 44
Section 956 - PLR 200832024 FC U.S. Parent U.S. Sub Unrelated Pship agreement specifies that FC will share only in the income, gains, deductions and losses of the Non-U.S. business and will have liquidation rights only in assets of the Non-U.S. business. Pship FC not treated as holding interest in the U.S. business under Treas. Reg. 1.956-2(a)(3). LLC1 (U.S.) LLC2 (Non- U.S.) 45
Section 956 PLR 200832024 (Cont'd) FC U.S. Parent Pship U.S. Sub Unrelated Accordingly, a CFC that has an economic interest in U.S. property through a partnership would be considered to have an interest in U.S. property for purposes of Section 956 in accordance with the substance of the arrangement. On the other hand, a CFC that does not have, directly or indirectly, any economic interest in U.S. property through a partnership, including a profits interest, a capital interest, a liquidation right, or any other interest, does not have an interest in U.S. property for purposes of Section 956. LLC1 (U.S.) LLC2 (Non- U.S.) Consider Rev. Rul. 55-39; Prop. Treas. Reg. 301.7701-1(a)(5); PLR 200803004. 46
Section 956 CFC Loans to Partnerships U.S. Parent As a general matter, obligations of a U.S. partnership are U.S. property but obligations of a foreign partnership are not. US1 US2 CFC Section 956(c)(1)(c) refers to obligations of a United States person. Section 957(c) (by reference to Section 7701(a)(30)) defines United States person to include domestic partnerships. FP Loan Conversely, there is nothing in the Code or regulations that provides that an obligation of a foreign partnership is an investment in U.S. property, even where the foreign partnership has U.S. partners or when the loan proceeds are then invested in U.S. property. The IRS has requested comments regarding the application of Section 956 in the case of a loan by a CFC to a foreign partnership in which one or more partners are U.S. shareholders of the CFC. Are regulations forthcoming? 47
CFC Loans to Partnerships Other Issues U.S. Parent Should regulations apply a tracing approach for Section 956? Examples of tracing: Use of Section 752 basis Proceeds invested by FP in U.S. property; US1 US2 CFC Proceeds distributed to US1 and US2. Distribute proceeds FP Loan Note that if the CFC s earnings are taxed under Section 956, and the cash is distributed to US1 and US2, there is potential doubletaxation when the loan is unwound 48
CFC Loans to Partnerships Other Issues US1 U.S. Parent US2 CFC As the IRS considers rules for determining whether obligations due from partnerships with U.S. partners constitute Section 956 property, what does one do with policy concerns stemming from hybrid entities? Hybrid FP Loan What if FP is taxed in its jurisdiction on its earnings from U.S. property? U.S. Property 49