While the current thinking in US political circles is that regulations must be eliminated because they burden business and thus curtail growth, when it comes to tax regulations, the opposite is true. Here, clarifications through tax regulations clearly help business as they provide certainty regarding tax costs, reports MNE Tax.
One example of an area where clarification would be especially desirable involves the tax treatment where the stock of a controlled foreign corporation (CFC) is held by a foreign partnership whose partners consist of US persons.
In such cases, several questions arise regarding how to apply section 961, which provides for basis adjustments when subpart F income is included in or excluded from gross income, and section 959, which excludes from gross income a distribution to a US shareholder of previously taxed subpart F income.
These provisions become indecipherable when you add to the mix section 958(a)(2), which deems US partners of a foreign partnership as the tax owners of CFC stock as if the partnership did not exist.
US subpart F rules
Sections 951 through 961 contain the principal rules requiring the current inclusion in gross income by a US shareholder of subpart F income, which generally consists of passive income, such as dividends and interest, earned by a CFC.
A US shareholder is defined in section 951(b) as a US person who owns or is considered as owning 10 percent or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation.
This definition ties into section 951(a), which requires the inclusion in gross income of subpart F income of US shareholders, and also ties into the definition of CFC in section 957(a), which requires the ownership by US shareholders of more than 50 percent of either the total voting power of all classes of stock entitled to vote or the total value of the stock of the corporation.
Section 951 provides that subpart F income is included in the gross income of US shareholders as if it were distributed by the CFC on a current basis, without regard to any actual transfers by the foreign corporation. Section 961(a) in turn provides for a positive basis adjustment to the CFC stock held by a US shareholder, or to the US shareholder’s partnership interest in a foreign partnership (or other foreign entity) that holds that stock.
The basis adjustment to the partnership interest is necessary because section 958(a)(1)(B) and 958(a)(2) treat stock held indirectly through foreign entities as if it were owned directly by the US shareholder.
To avoid double taxation when the earnings that have been previously taxed as subpart F income are later distributed to the US shareholders, section 959 provides for exclusion of this previously taxed income (PTI).
CFCs held by foreign partnerships with US partners
There is a need for guidance on the application of sections 959 and 961 to stock of a CFC held by a foreign partnership whose partners consist of US persons.
Specifically, section 958(a)(1)(B) and 958(a)(2) treat stock owned by a foreign partnership as being owned proportionately by its partners.
This means that, under section 951(a)(1)(A), the US partners of a foreign partnership who meet the US shareholder ownership test of section 951(b) are required to include the subpart F income of the CFC owned by the foreign partnership in gross income as if the US partners owned that stock directly.
Section 951(b), in defining a US shareholder, refers to ownership under section 958(a), which includes ownership through a foreign partnership.
In those cases, section 961(a) refers to “the basis of property of a United States shareholder by reason of which he is considered under section 958(a)(2) as owning the stock of a controlled foreign corporation” in providing for an increase in basis by the amount included in gross income under section 951(a).
Reg. sections 1.961-1(a)(1)(i) and (ii) and 1.961-1(b)(1)(ii) provide for such a basis increase to the stock of a CFC or the interest in the foreign partnership that owns the stock under local law.
Similarly, section 961(b)(1) and reg. section 1.961-2(a)(1)(i) and (ii) provide for a basis decrease to the CFC stock or to the basis in the foreign partnership that owns the stock in the case of an amount excluded from gross income as PTI under section 959(a).
Although section 961 provides for both increases and decreases to the basis of the stock of a CFC, or the basis of an interest in a foreign partnership owning that stock, it is not clear that a US shareholder (or US person) would receive an increase in basis in the CFC stock and its partnership interest on the same subpart F inclusion.
In the case of a foreign partnership that owns stock in a CFC, if the US partners of that partnership have a subpart F inclusion and a corresponding basis increase in their partnership interests, does the foreign partnership also obtains a basis increase in the stock of the CFC that it owns under local law, given that it is the partners of that partnership who include the amounts of subpart F income in gross income?
As stated earlier, section 958(a)(1)(B) and 958(a)(2) treat stock of a CFC owned by a foreign partnership as held directly by the US partners for purposes of subpart F. Section 959 treats the payment of undistributed subpart F income as PTI.
Section 961(a) and (b) are intended to adjust stock basis when there is a subpart F inclusion and a later distribution of PTI (otherwise, a subsequent taxable disposition of a CFC with a PTI account would yield a second tax on the same earnings).
To prevent overtaxation of the US partners of the partnership, the foreign partnership should get a basis increase in the CFC stock for the subpart F inclusion of the US partners and the foreign partnership should also be entitled to the PTI exclusion on a later distribution of the PTI from the CFC to the foreign partnership.
The US partners should also be entitled to correlative positive and negative adjustments for the PTI exclusion of the foreign partnership (as if it was tax-exempt income under section 705(a)(1)(B)) and for the distribution of the PTI from the CFC to the foreign partnership, and then from the foreign partnership to its partners (under section 705(a)(2)), so as to achieve the correct economic results: the taxation of the subpart F income only one time, regardless of where in the chain of ownership the PTI resides.
It must be pointed out, however, that some practitioners have found it difficult to get comfortable with the idea that there is a section 961(a) or (b) basis adjustment to the shares of the CFC held by a foreign partnership under the current statute and its implementing regulations for two reasons.
First, reg. sections 1.961-1(a)(1)(i) and (ii) and 1.961-1(b)(1)(ii) provide for an adjustment to the US shareholder’s basis in either stock in the CFC or the US shareholder’s basis in the property (for example, a foreign partnership interest) through which ownership of the CFC shares is attributed to the US shareholder.
The regulations do not explicitly provide for an increase in both the US shareholder’s basis in its foreign partnership interest and the foreign partnership’s basis in the CFC shares.
Second, an analogous problem existed before 1997 for stock of lower-tier CFCs. Section 961 did not provide for an adjustment to the basis of the stock of a lower-tier CFC in the hands of a first-tier CFC when there was a subpart F inclusion from the lower-tier CFC.
Congress added section 961(c) to address this problem, but section 959(c) by its terms applies only to stock of a lower-tier CFC held by an upper-tier CFC. The analogous issue regarding shares of a CFC held by a foreign partnership was not addressed in this 1997 legislative amendment to the statute.
It is believed that the appropriate basis adjustments could be provided by regulation and would not require a statutory change. Guidance is necessary to provide for the correct economic results and to provide for a rational result to the statutory regime first enacted by Congress in 1962 (when subpart F was first enacted into law).
Under one approach, this treatment of basis increases and decreases would be as follows: first, the subpart F inclusion by the US partners causes an increase in the basis of the CFC stock in the hands of the foreign partnership with respect to the US partners of that partnership; second, a distribution of the PTI to the foreign partnership is treated as tax-exempt income in the hands of the foreign partnership with respect to the US partners of that partnership.
Alternatively, for purposes of determining basis increases in the CFC stock, the CFC stock would be treated, immediately before the subpart F inclusion by the U.S. partners, as if it had been distributed by the foreign partnership to the partners and then recontributed to the partnership immediately after the subpart F inclusion.
Similarly, in determining basis decreases, the CFC stock would be treated as if it had been distributed to the US partners immediately before the distribution of PTI to the partners and then as if the stock was recontributed to the partnership immediately after that PTI distribution.
Regulations should be proposed under sections 705, 959, and 961 that provide for the treatment of subpart F inclusions, PTI distributions, and basis increases and decreases that take into account the hodgepodge created by section 958(a)(2) that treats the US partners of a foreign partnership as the tax owners of the CFC stock as if they held that stock directly.
The rules of subchapter N require that the US partners of the foreign partnership treat the stock as owned by them directly, but those rules do not override the rules of subchapter K in determining the basis and tax consequences to the partners of transactions regarding the foreign partnership and its partners.