The Federal Anti-Deferral Rules for Foreign Income –Just a Reminder, There’s No Easy Way Out
July 20, 2020
It’s Complicated
Coming to grips with the U.S. tax treatment of the foreign-sourced income of a closely held domestic business, and of commercial transactions involving such a business and its related foreign entities, may be intimidating not only for the owners of the business, but also for their advisers.
Indeed, the Code and Regulations include a number of complex rules that are aimed at the overseas activities and investments of U.S. businesses. Many of these involve situations that Congress and the Treasury have determined may result in the improper deferral, or even the permanent avoidance, of U.S. income tax.[i]
That being said, there are many other instances in which an owner’s application of basic U.S. tax principles, identical to those that are routinely encountered in strictly domestic transactions, may prevent a U.S. business from getting into trouble with the IRS, as one taxpayer (“Taxpayer”) recently discovered.[ii]
Before considering Taxpayer’s circumstances, a very brief review of the regime that governs the taxation of the foreign income and activities of U.S. businesses may be in order.
Taxation of Overseas Activities
In general, the U.S. taxes its citizens and residents – including both natural persons and legal entities – on both their U.S. and foreign-sourced income.[iii] For example, the foreign-sourced income attributable to the foreign branch[iv] of a domestic business is subject to U.S. income tax on a current basis; the same is true for foreign-sourced income realized by a domestic or foreign partnership of which the U.S. person is a member.
This general rule is qualified, somewhat, when the foreign-sourced income is realized by a foreign corporation in which a U.S. person is a shareholder. For example, a U.S. person who is a shareholder of a foreign corporation that is engaged in the active conduct of a foreign business will not be subject to U.S. income tax with respect to their share of the corporation’s foreign-sourced income until such income is distributed as a dividend to the U.S. person.
Over the years, however, the U.S. has enacted various anti-deferral rules that require certain U.S. persons to include in their gross income their share of foreign-sourced income that is realized by a foreign corporation of which they are a shareholder.
Subpart F
The main U.S. anti-tax-deferral regime, which addresses the taxation of income earned by controlled foreign corporations (“CFC”),[v] may cause the “U.S. Shareholders” of a CFC to be taxed currently on their pro rata share of certain categories of income earned by the CFC – “Subpart F income” – regardless of whether the income has been distributed to them as a dividend.[vi]
For most U.S. Shareholders, Subpart F income generally includes “foreign base company income,”[vii] which consists of “foreign personal holding company income” (such as dividends, interest, rents, and royalties), and certain categories of income from business operations that involve transactions with “related persons,” including “foreign base company sales income” and “foreign base company services income.”[viii]
Specifically, foreign base company sales income is income derived by a CFC from a purchase or sale of personal property involving a related party in which the property is both manufactured and sold for use/consumption outside the CFC’s country of organization,[ix] and foreign base company services income is income derived by a CFC in connection with the performance of services outside the CFC’s country of organization for or on behalf of a related person.[x]
However, the pro rata amount that a U.S. shareholder of a CFC is required to report as Subpart F income of the CFC for any taxable year cannot exceed the CFC’s current earnings and profits.[xi] After all, the purpose of Subpart F is to deny deferral of U.S. taxation; it cannot require that a U.S. shareholder of a CFC be taxed on amounts in excess of the dividends they would have received if all of the CFC’s income had been distributed currently.[xii]
GILTI
In 2017, the TCJA[xiii] introduced a new class of income – global intangible low-taxed income (“GILTI”) – that must be included in the gross income of a U.S. Shareholder of a CFC, and which further eroded a U.S. person’s ability to defer the U.S. taxation of foreign-sourced business income.
This provision requires the current inclusion in income by a U.S. Shareholder of (i) their share of all of a CFC’s non-subpart F income (other than income that is effectively connected with a U.S. trade or business and income that is excluded from foreign base company income by reason of the “high-tax” exception[xiv]), (ii) less an amount equal to the U.S. Shareholder’s share of 10% of the adjusted basis of the CFC’s tangible property used in its trade or business and of a type with respect to which a depreciation deduction is generally allowable; the difference is the shareholder’s GILTI.[xv]
In the case of an individual, the maximum federal tax rate on GILTI is 37%. This is the rate that will apply, for example, to a U.S. citizen who directly owns at least 10% of the stock of a CFC.
More forgiving rules apply in the case of a U.S. Shareholder that is a C corporation. For taxable years beginning after December 31, 2017, and before January 1, 2026, a regular domestic C corporation is generally allowed a deduction of an amount equal to 50% of its GILTI; thus, the federal corporate tax rate for GILTI is actually 10.5% (the 21% flat rate multiplied by 50%).[xvi]
With the foregoing rules in mind, let’s consider Taxpayer’s situation.
South of the Border[xvii]
Taxpayer was a U.S. citizen residing in Mexico. During the years at issue,[xviii] they operated a real estate development and construction business in Mexico. They also owned 50% of Mex-Corp, a Mexican corporation, of which Taxpayer was the president. At some point, Taxpayer transferred 41% of their 50% ownership interest in Mex-Corp to an unrelated individual (“NRA”) who was a Mexican citizen, and who was never an officer or director of Mex-Corp. Taxpayer entered into a consulting and personal services contract with Mex-Corp, and the corporation made payments to Taxpayer for their services.
In order to manage their real estate development and construction activities, Taxpayer incorporated Foreign-Corp in the Bahamas, with the corporation’s bearer shares held by Taxpayer.[xix] The following year, Taxpayer reincorporated Foreign-Corp in Belize. In the process, Taxpayer retroactively amended the corporation’s organizational documents effective as of its original incorporation; these were also amended to reflect that Taxpayer held a 27% ownership interest, and NRA held the remaining 73% ownership interest in Foreign-Corp. Taxpayer was the president and a director of Foreign-Corp.
Taxpayer opened accounts in Foreign-Corp’s name with various financial institutions, and had sole signature authority over each of these accounts.[xx] The application submitted to open one of the accounts identified Taxpayer as Foreign-Corp’s sole director, and described Foreign-Corp’s shareholders as two “bearers” holding one share each of its capital stock. The documents for another account identified Taxpayer as the beneficial owner of the account, and as the “only shareholder and owner;” it described the account’s purpose as “[w]ealth [m]anagement of retirement funds; probably [a] loan for [a] flat in Paris.”
In addition to maintaining at least one personal bank account and several personal brokerage accounts and credit cards, Taxpayer maintained several business credit cards where Foreign-Corp and Taxpayer were listed as the primary cardholders and authorized users.
Foreign-Corp did not compensate Taxpayer by check or direct deposit for the years at issue; instead, it would transfer funds from one of its accounts to Taxpayer’s personal account, or it would directly pay some of Taxpayer’s personal expenses, including personal credit card charges, travel expenses, household furnishings, tuition, gifts to relatives, and rent for an apartment; in addition, Foreign-Corp would transfer funds from its accounts to Mex-Corp “in lieu of salary” to Taxpayer.
Mex-Corp and Foreign-Corp entered into a five-year joint venture (“JV”) agreement to acquire, develop, and sell residential real property in Mexico. Taxpayer managed the JV’s affairs and funds, and served as its managing partner. Taxpayer was also given powers of attorney to act jointly and independently as the attorney-in-fact of JV. As JV’s attorney-in-fact, Taxpayer was authorized to retain any assets owned by JV and to reinvest those assets, co-own assets and commingle Taxpayer’s funds with the funds of JV, and to personally gain from any transaction completed on JV’s behalf.[xxi]
Audit and Determination
Taxpayer’s federal income tax returns for the years at issue – all predating the TCJA and the addition of the GILTI inclusion rule to Subpart F – reported adjusted gross income consisting of wages (from Mex-Corp), interest, ordinary dividends, rent, and “other income.”[xxii]
The IRS audited Taxpayer’s returns.[xxiii] Based on its examination, the IRS identified various corporate disbursements or transfers to Taxpayer or for Taxpayer’s benefit. The IRS determined that Taxpayer had additional wage income from Foreign-Corp, or in the alternative, additional dividend income. Specifically, for the years at issue, the IRS determined that Taxpayer’s additional wage income was attributable to withdrawals from various corporate financial accounts for Taxpayer’s personal use, including for the payment of their personal expenses.
The IRS also determined that Foreign-Corp was a CFC that was 100% owned by Taxpayer for the years at issue, that the investment income from Foreign-Corp’s various accounts was foreign personal holding company income (“FPHCI”) under Subpart F of the Code and, as a result, that Taxpayer was required to report their pro rata share (100%) of that FPHCI as Subpart F income, which was taxable as additional ordinary dividend income.
A notice of deficiency was sent to Taxpayer which reflected these determinations,[xxiv] and which also proposed the imposition of the 20% accuracy-related penalty. In response, Taxpayer timely filed a petition with the U.S. Tax Court.[xxv]
Additional Wage Income?
The Court began with the basics: (i) a taxpayer’s gross income includes “all income from whatever source derived,” (ii) a taxpayer is required to maintain books or records sufficient to establish the amount of his or her gross income required to be shown by such person on any return, and (iii) if the taxpayer’s books or records do not clearly reflect income, then the IRS is authorized “to reconstruct income in accordance with a method which clearly reflects the full amount of income received.”[xxvi]
During the audit, the IRS determined[xxvii] that Taxpayer had additional wage income from Foreign-Corp. Notwithstanding Taxpayer’s contention to the contrary, the Court found that Taxpayer offered no evidence to support their position aside from self-serving testimony, which the Court found was not credible. “As we have stated many times before, this Court is not bound to accept a taxpayer’s self-serving, unverified, and undocumented testimony.” Accordingly, based upon the corporate expenditures made in satisfaction of Taxpayer’s personal expenses, the Court sustained the IRS’s determination of additional wage income for the years at issue.
Subpart F Income
Having addressed the issue of unreported wages, the Court then turned to the IRS’s assertion of Taxpayer’s unreported Subpart F income.
The Court explained that, under Subpart F, a U.S. shareholder of a CFC must generally include in their gross income for a taxable year their pro rata share of the CFC’s “Subpart F income” for such year. A U.S. shareholder with respect to any foreign corporation, the Court continued, is a U.S. person “who owns . . . , or is considered as owning by applying [certain] rules of ownership . . . 10% or more of the total combined voting power of all classes of stock entitled to vote” of the foreign corporation. The Court stated that a CFC is “any foreign corporation if more than 50% of (1) the total combined voting power of all classes of stock of such corporation entitled to vote, or (2) the total value of the stock of such corporation, is [directly or constructively] owned . . . by United States shareholders on any day during the taxable year of such foreign corporation.” And finally, the Court observed that Subpart F income includes foreign base company income, which includes FPHCI, which in turn includes dividends, interest, and the excess of gains over losses from the sale or exchange of certain property.
The IRS determined that Taxpayer had reportable Subpart F income – specifically, the investment income from Foreign-Corp’s bank and investment accounts – during each of the years at issue.
CFC?
According to the Court, Taxpayer disputed whether Foreign-Corp was a CFC on any day during each of the years at issue, with the result that if Foreign-Corp was a CFC, then Taxpayer had reportable Subpart F income for those years.
It was the IRS’s position that Foreign-Corp was a CFC (and, thus, that Taxpayer had reportable Subpart F income) because Taxpayer held a 100% ownership interest in Foreign-Corp. Taxpayer, on the other hand, contended that Foreign-Corp was not a CFC (and thus they did not have any reportable Subpart F income) because Taxpayer held no more than a 27% ownership interest in Foreign-Corp during the years at issue.
Relying upon an earlier decision[xxviii] involving this very claim, the Court rejected Taxpayer’s contention that the bearer shares that gave them 100% ownership in Foreign-Corp were eliminated and that the share ownership structure changed, reducing Taxpayer’s ownership to 27% for the years in issue. To support this claim, Taxpayer provided Foreign-Corp’s backdated amended organizational documents showing that Taxpayer held a 27% interest. However, the Court stated that nothing in the record indicated an actual change in ownership aside from Taxpayer’s self-serving testimony and the backdated amended documents. What’s more, Taxpayer was the president and a director of Foreign-Corp. Thus, the Court concluded that Taxpayer held a 100% interest in Foreign-Corp, and that the corporation was a CFC for the years in issue.
Consequently, Taxpayer was required to report as gross income their pro rata share of Foreign-Corp’s Subpart F income for the years at issue. Given that Taxpayer was the 100% shareholder of Foreign-Corp for those years, Taxpayer had to report 100% of Foreign-Corp’s Subpart F income for those years.
Moreover, the Court sustained the IRS’s imposition of the 20% accuracy-related penalty on Taxpayer’s underpayment of the tax required to be shown on their tax return, finding that such underpayment was attributable to Taxpayer’s “negligence or disregard of rules or regulations” and/or a “substantial understatement of income tax,”[xxix] and Taxpayer’s failure to demonstrate that they had acted in good faith with respect to, and had shown reasonable cause for, such underpayment.[xxx]
Lesson Learned?
Taxpayer didn’t stand much of a chance. They were not adequately compensated, as such, for their services to Foreign-Corp; instead, Taxpayer’s compensation was disguised – barely – through the payment of various personal expenses.[xxxi]
Taxpayer’s attempt at avoiding the Subpart F inclusion rules, by using a mere straw man (NRA) to hold shares of Foreign-Corp stock, was equally unavailing.
Such transparent attempts at avoiding the anti-deferral rules of Subpart F of the Code are ill-advised.
However, there is another “extreme” approach that is almost as bad. I am referring to those advisers who, seemingly for their own convenience, choose to report all of a CFC’s foreign-sourced income on the U.S. Shareholder’s federal income tax return without considering the applicable rules or analyzing any opportunities for deferral.
Somewhere in between these two sets of advisers are those folks who dedicate varying degrees of attention to the application of the Subpart F rules at the federal level, but who may not be familiar with their application by state and local taxing authorities – after all, not every domestic jurisdiction has fully conformed to these federal anti-deferral rules.
In the case of New York, for example, it is important for advisers to recognize that 95% of GILTI required to be included in a corporate taxpayer’s federal gross income[xxxii] is excluded from New York State taxation as “exempt CFC income” for tax years beginning on or after January 1, 2019.[xxxiii] By contrast, similar legislation was not enacted with respect to either New York City’s general corporation tax or its business corporation tax.
There’s a lot to chew on here, but there’s no substitute for working through the details.
[i] Although not relevant to the discussion here, IRC Sec. 367 generally prevents the tax-free reorganization rules from allowing certain transactions to remove assets or income from the tax jurisdiction of the U.S.
[ii] Flume v. Comm’r, T.C. Memo. 2020-80.
[iii] Most U.S. tax treaties include a so-called “savings clause” that allows the U.S. to tax its residents as if the treaty were not in force. This provision is intended to prevent U.S. residents from using the treaty to reduce their U.S. income tax liability. See Article 1, Paragraph 4 of the U.S. Model Income Tax Convention.
[iv] This includes a foreign “eligible” entity owned by the U.S. business that has elected to be treated as a disregarded entity for U.S. tax purposes. Reg. Sec. 301.7701-3; IRS Form 8832, Entity Classification Election.
[v] IRC Sec. 957. A CFC is defined as any foreign corporation in which U.S. persons own (directly, indirectly, or constructively) more than 50% of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons who own at least 10% of the foreign corporation’s stock (measured by vote or value; each a “United States shareholder”).
Under the CFC rules, the U.S. generally taxes the U.S. Shareholder of a CFC on their pro rata shares of the CFC’s “Subpart F income,” without regard to whether the income is distributed to the shareholder. In effect, the U.S. treats the U.S. Shareholder of a CFC as having received a current distribution of their share of the CFC’s Subpart F income.
[vi] IRC Sec. 951.
[vii] IRC Sec. 954.
[viii] One exception to the definition of Subpart F income permits continued U.S.-tax-deferral for income received by a CFC in certain transactions with a related corporation organized and operating in the same foreign country in which the CFC is organized (the “same country exception”).
Another exception is available for any item of income received by a CFC if the taxpayer establishes that the income was subject to an effective foreign income tax rate greater than 90% of the maximum U.S. corporate income tax rate (the “high-tax exception”). In theory, the 21% U.S. federal corporate income tax rate should make it easier to qualify for this exception.
[ix] IRC Sec. 954(d).
[x] IRC Sec. 954(e).
[xi] IRC Sec. 952(c)(1)(A).
[xii] A CFC’s current earnings and profits are generally determined according to rules substantially similar to those applicable to domestic corporations. IRC Sec. 964; Reg. Sec. 1.964-1.
[xiii] Tax Cuts and Jobs Act (“TCJA”). P.L. 115-97.
[xiv] IRC Sec. 954(b)(4).
[xv] IRC Sec. 951A.
[xvi] IRC Sec. 250(a)(1)(B). However, see the election under IRC Sec. 962;
[xvii] Speaking of which, have you seen the 2004 movie, “The Day After Tomorrow,” with Dennis Quaid and Jake Gyllenhaal? As a result of climate change, most of the Northern Hemisphere is cataclysmically plunged into an ice age, and the U.S. population flees south, to Mexico. When normal access points are blocked by the Mexican government, folks start wading across the Rio Grande. Interesting premise. Total non sequitur here, of course.
[xviii] Which preceded the TCJA.
[xix] The following year, it was reincorporated in Belize.
[xx] Presumably, Taxpayer filed FinCEN Form 114 (the FBAR filing).
[xxi] This falls under the category of “you can’t make this shit up.”
[xxii] Taxpayer claimed the earned income exclusion and certain NOL carryovers.
[xxiii] During the course of the exam, Taxpayer provided some, but not all, of the records requested by the IRS. At that point, the IRS issued third-party record keeper summonses to several U.S. financial institutions, brokerage companies, and credit card companies, and as a result of those summonses received additional records pertaining to Foreign-Corp’s accounts with those institutions and companies.
[xxiv] The IRS first notified Taxpayer of the proposed changes by way of a so-called “30-day letter,” which transmitted an examination report and various worksheets detailing the calculations of the proposed deficiencies and penalties. (The examination report is commonly called a “revenue agent’s report” or “RAR”.) This consisted of a Form 4549-A, Income Tax Examination Changes, and a Form 886-A, Explanation of Items.) The 30-day letter also explained that Taxpayer could request a conference with the IRS Office of Appeals by submitting a formal protest. The letter further advised that if Taxpayer failed to reach an agreement with Appeals or if they did not respond to the letter, then a notice of deficiency would be issued to them. IRC Sec. 6212 and Sec. 6213.
[xxv] In general, the IRS’s determinations set forth in a notice of deficiency are presumed correct and the taxpayer bears the burden of proving otherwise. See Tax Court Rule 142(a). However, for this presumption to adhere in cases (such as this one) involving unreported income, the IRS must provide some reasonable foundation connecting the taxpayer with the income-producing activity. Once the IRS has done this, the burden of proof shifts to the taxpayer to prove by a preponderance of the evidence that the IRS’s determinations of unreported income are arbitrary or erroneous. On the basis of what it described as “credible evidence,” the Court here was satisfied that the IRS had proved that Foreign-Corp was a likely source of the determined unreported income for the years at issue. Thus, as to this income, the burden of proof shifted to Taxpayer to show that the IRS’s determinations in this regard were arbitrary or erroneous.
[xxvi] Reg. Sec. 1.446-1 and Reg. Sec. 1.6001-1.
[xxvii] The IRS used the specific item method to make these determinations. The specific item method is a Court-approved “method of income reconstruction that consists of evidence of specific amounts of income received by a taxpayer and not reported on the taxpayer’s return.”
[xxviii] Flume v. Comm’r, 2017-21. “Issue preclusion,” the Court explained, “applies when suits involve separate claims, but present some of the same issues, and ‘bars the relitigation of issues actually adjudicated, and essential to the judgment, in a prior litigation between the same parties.’ ” Issue preclusion focuses on whether (1) the issue in the second suit is identical in all respects with the one actually litigated, decided, and essential to the judgment in the first suit, (2) a court of competent jurisdiction rendered a final judgment in the first suit, (3) the controlling facts and applicable legal principles in the second suit have changed significantly since the judgment in the first suit, and (4) there are special circumstances, such as fairness concerns, that warrant an exception to preclusion in the second suit.
[xxix] IRC Sec. 6662.
[xxx] IRC Sec. 6664.
[xxxi] These could just as easily have been treated as constructive dividend distributions.
[xxxii] Under IRC Sec. 951A(a) (without regard to the GILTI deduction under IRC section 250).
[xxxiii] NY Tax Law Sec. 208.6-a(b); TSB-M-19(1)C.