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US CFC Rules: What Income Is Included?

The CFC rules regarding income inclusion have to thread a very small needle.  On one hand, they need to prevent US taxpayers from moving offshore, thereby taking advantage of a technical reading of the US tax code that prevents taxation of non-US (foreign) corporations (see discussion here).  On the other hand, they can't be so restrictive they prevent US corporations from  expanding internationally, thereby hindering legitimate business development.  In effect, the rules need to exclude income derived from "legitimate" business expansion but include evasion.

Before moving forward, be advised: below is a general summation of the CFC income inclusion rules: there are many nuanced ins and outs to these rules that are far beyond the scope of a blog post.  

So -- if a corporation is a CFC, what income do we include in the US taxpayer's income for the taxable year?  Under section 951(a)(1)(A)(i) we include the taxpayers "pro rate share of sub-part F income" which is more completely defined in section 954 and the accompanying treasury regulations.  The code defines Subpart F income as being  "foreign base company income" which is further broken down "foreign personal holding company income," "foreign base company sales income" and "foreign base company services income."  Let's look at each one of these sub-sections as defined in the treasury regulations.

Foreign personal holding company income is designed to include the income from offshore investment accounts.  As such it includes dividends, capital gains, interest, commodities and currencies transactions and all other manner of standard investment transactions.  In short, if a US person wants to move his investment account to the Cayman's and place it into a corporation, this provision would include all the trading income from the account in his income for the taxable year. 

Foreign base company sales income "consist of gross income (whether in the form of profits, commissions, fees or otherwise) derived in connection with the purchase of personal property from a related person and its sale to any person, the sale of personal property to any person on behalf of a related person, the purchase of personal property from any person and its sale to a related person, or the purchase of personal property from any person on behalf of a related person."  

In general, here's what the rules are trying to prevent: using an offshore entity to act as a sales agent for a US company and then structuring transactions with that sales company to effectively transfer income to this low-tax entity.  

There are two very important exclusions to this rules which are:

Foreign base company sales income does not include income derived in connection with the purchase and sale of personal property .... if the property is manufactured, produced, constructed, grown, or extracted in the country under the laws of which the controlled foreign corporation which purchases and sells the property (or acts on behalf of a related person) is created or organized.

AND

Foreign base company sales income does not include income derived in connection with the purchase and sale of personal property .... if the property is sold for use, consumption, or disposition in the country under the laws of which the controlled foreign corporation which purchases and sells the property (or sells on behalf of a related person) is created or organized or (b), where the property is purchased by the controlled foreign corporation on behalf of a related person, 

So -- the definitions exclude income if the company is not simply forming an offshore sales agent but instead is looking to actually develop a market in the company of incorporation.

And finally, we exclude "foreign base company services income", which is 

... income of a controlled foreign corporation, whether in the form of compensation, commissions, fees, or otherwise, derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services which—

(1) Are performed for, or on behalf of a related person, and

(2) Are performed outside the country under the laws of which the controlled foreign corporation is created or organized.

Put more generally, a company can't transfer it's human capital offshore and then trap the profits earned by the human capital offshore.

Remember that the above rules generally summarize the big points of the CFC income inclusion rules; there are many nuanced points contained in the treasury regulations that go far beyond the confines a blog post.  But, the above inclusions do provide a good start for outlining the broad strokes of the law.

  

US CFC Rules: What Is A US Shareholder?

Like most subparts in the US tax code (the CFC rules are a sub-part to sub-chapter N in the code), the CFC rules have specific concepts and definitions that apply only to this particular sub-part.  The most important definition is that of a "US shareholder."  In addition, like most sections in the code, the CFC rules require us to reference multiple sections to get a complete definition.

Let's start with section 957, which states:

For purposes of this subpart, the term “controlled foreign corporation” means any foreign corporation if more than 50 percent 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 owned (within the meaning of section 958 (a)), or is considered as owned by applying the rules of ownership of section 958 (b), by United States shareholders on any day during the taxable year of such foreign corporation.

Remember that under the tax code's definitions section (section 7701), a "foreign" corporation is one not formed in the US.  So, according to the CFC definition, a non-US company that is owned by a "US shareholder" is a CFC.  This, of course, leads us to define a "US shareholder" which is defined in section 951(b):

For purposes of this subpart, the term “United States shareholder” means, with respect to any foreign corporation, a United States person (as defined in section 957 (c)) who owns (within the meaning of section 958 (a)), or is considered as owning by applying the rules of ownership of section 958 (b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation.

And finally, attribution rules from section 318 apply under section 358, preventing a US resident from diversifying his ownership over several companies and or family members to theoretically prevent technical ownership while still actually remaining in control.

 

Putting these two sections together, we arrive at the following definition:  if more than 50% of the combined voting power of a foreign (non-US company) is owned by a "US shareholder(s) (individuals who each own at least 10% of the stock)" we have a controlled  foreign corporation, thereby requiring us to include certain types of income from that company in each shareholder's gross income on a pro-rata basis. 

It's very important to note that we have two ownership thresholds to meet in this definition.  First, we have to establish majority control by "US shareholders."  This means that if the foreign corporation is majority owned by foreigners (non-US individuals), a CFC does not exist.  In addition, we only have to include certain types of income in the personal gross income of US residents who own more than 10% of the company. 

Next, we'll start to look at what types of income we need to include.

The US Controlled Foreign Corporation (CFC Rules): An Introduction

     Commentators and practitioners often refer to the US controlled foreign corporation statute (or "CFC") as extremely complex and Byzantine in their construction and application.  I would agree with this assessment to a point; if someone is simply trying to learn the pure mechanics of the statute then, yes, it is very difficult to fathom.  However, when one looks at the rules after understanding the underlying policy for their implementation and overall effect, the statutory scheme becomes easier to comprehend.  So, let's begin with an explanation of why the US (and other developed, OECD countries) put these types of rules into place.

     To begin we will need to know a few definitions from section 7701.   A domestic corporation is one "created or organized in the United States or under the law of the United States or of any State" while a foreign corporation is "one that is "is not domestic."  Moving one step further, a foreign corporation is taxed by the US on income that is either connected with a "United States business" or is derived from sources within the United States.  Putting all of these definitions together into a workable (and far more user friendly) statement, the US taxes a foreign corporation when that corporation either formally engages in a trade or business within US borders or derives some type of profit from an activity within the US.  While this all may seem a bit obvious, knowledge of these definitions is key to understanding why the US implemented CFC rules.

     Next, it's important to remember the US taxes US corporations and individuals on world wide income (income from "whatever source derived").  But given the above definitions, it would be possible for a US person to transfer his assets to a foreign company thereby removing the income from the US taxation, as that company would have no taxing nexus with the US -- they were not conducting a trade or business within the US or engaging in any non-business related transaction.  And as the entity was not a partnership, the income would not pass through to the individual. And this is exactly what was happening to a larger extent in the 1950s -- US corporations and individuals would form foreign corporations outside the US' taxing jurisdiction while still living and residing in the US.  This creates a "free rider" problem: people or companies who live/reside in the US receive all the benefits of taxpayer funded programs (the interstate system, public education, a judiciary to name a few) without funding them through taxes.  And it is that behavior which the CFC rules were designed to prevent.

     In general, the CFC rules attribute offshore corporate income to US shareholders when the perceived purpose of the offshore corporation is not to engage in legitimate foreign business (such as opening a "bricks and mortar" branch to sell products) but instead to divert income to a low-tax jurisdiction with the sole intent of removing it from the US tax base.  As we move forward into a general overview of the CFC mechanics, keep this concept in mind as it helps to clarify the underlying CFC policy and makes the overall rules that much easier to understand.

      

Captives And Life Insurance: A Bad Combination

     No topic splits the captive insurance world more than the issue of life insurance — or, more specifically, whether or not a captive can purchase a whole life policy as part of its investment portfolio. Those in favor point to the stable returns offered by whole life and the fact that banks are allowed to purchase BOLI as primary reasons for favoring the practice. Those against the practice cite anti-avoidance law along with the IRS’s long history of successfully attacking more aggressive life insurance plans as negative factors. Adding further fuel to the fire is the lack of any formal guidance from the IRS on the issue, leaving both camps with enough legal wiggle room to claim validation.

     I have always fallen in the negative camp, largely based on anti-avoidance law concerns. By way of quick background, anti-avoidance law is a series of judicial doctrines used by the courts and the IRS to attack transactions largely on “substance over form” grounds. This doctrine has a long and extremely convoluted legal history, which can be traced to the Gregory v. Helvering case, and stretches to well over 1,000 citations in cases, law review articles and legal treatise. Highly questionable annuity and life insurance transactions are at the center of several of the more famous citations, such as Knetsch (which involves and annuity transaction) and In Re CM Holdings (which is one of four COLI cases from the 1900s and early 2000s).

     Firmly hardening my antagonism to this transaction is a recent law review article by Beckett Cantley, law professor at John Marshall School of Law in Atlanta. His piece, "Historical IRS Policy Weapons to Combat CIC Deductible Purchases of Life Insurance, provides the most in-depth treatment of this transaction, highlighting the IRS’ successful attacks on more aggressive life insurance planning, the policy reasons behind those attacks and the application of the reasoning of those successful prosecutions to captive purchases of life insurance.

     He concludes, “The IRS will likely view an arrangement where a small business owner funds a CIC for the primary purpose of obtaining deductions on life insurance premium payments (“Insurance Transaction”) as similarly abusive to prior listed transactions involving I.R.C. § 419 plans, I.R.C. § 412(e)(3) plans, and I.R.C. § 831(b) PORCs.”

     Professor Cantley outlines the basic argument that would allow the IRS to successfully challenge these transactions.

     The starting point is section 264(a) of the tax code, which states: “No deduction shall be allowed for—(1) Premiums on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract.”

     The underlying policy reason for this is to prevent tax free accumulation of income, which would disproportionately benefit high-net-worth individuals. If this deduction were allowed, a high-net-worth business owner would be able to purchase vast amounts of life insurance coverage, deduct those premiums as a trade or business expense, and then have the tax-free proceeds benefit his family on his death.

     The next step is the premium payment from the parent company to the captive, which is tax deductible under 162(a) as a trade or business expense. This is followed by the captive’s purchase of life insurance, which benefits the captive owner by either naming his family or business as a beneficiary. Note what’s transpired with this transaction: The business owner has deducted the premium payment for a property and casualty policy, the proceeds of which have been used to purchase a life insurance policy that in some way benefits him. He has done indirectly (purchased life insurance via some type of deductible payment) what he can’t do directly (take a deduction for a life insurance payment via 264(a)). A general underlying concept in tax law is a taxpayer cannot do indirectly what he can't do directly. However, here, he has done just that.

     In addition, there are several basic anti-avoidance law theories which would underlie the services attacks; these involve application of the step transaction doctrine, the economic substance doctrine, general form over substance and the sham transaction doctrine. Professor Cantley outlines these arguments in far more detail in a forthcoming law review article titled, “Relearning the Lesson: IRS Judicial Doctrine Attacks on the Captive Insurance Company Tax Deductible Line Insurance tax Shelter.”  His analysis for all doctrines is very convincing, and indicates the Service has multiple avenues to successfully challenge this transaction.  

     One of the more unfortunate aspects of practicing law is we are forced to read the legal tea leaves when there is no formal guidance from the relevant authorities. However, in-depth research and a broad knowledge of the law often suffice where lack of guidance exists. Here, the history of anti-avoidance law, the general tax policy of preventing a tax deduction (either directly or indirectly) for purchases of life insurance and the IRS’s long and successful history of challenging aggressive life insurance transactions provide a clear picture: Purchasing life insurance as a portfolio investment in a captive insurance company should be avoided.  

Double Irish Loophole to Close

From CBS Marketwatch:

Ireland's finance minister, Michael Noonan, said Tuesday that he will work to close a legal loophole that allowed Apple Inc. AAPL +0.56% to sidestep big tax payments, the Financial Times reported on Wednesday. Noonan said he will publish leglislation that ensures companies registered in Ireland declare a tax residency in another jurisdiction or become liable for a 12.5% corporate tax rate in 2015.

Cadbury's Tax Plan and Inverse Mergers: More Corporate Tax Planning Enters the Spotlight

     One of the more interesting business reporting trends over the last few years is the focus on corporate tax planning.  I believe this started in conjunction with the investigations by the US and other OECD countries into offshore/tax haven planning mechanisms which has led to some embarrassing tax disclosures.  Regardless of the cause, we are seeing far more actual disclosure about aggressive corporate tax planning techniques.  For example, the Financial Times has recently issued a two part report on Cadbury's tax planning.  

Cadbury, the British confectionery maker that became a cause célèbre for tax justice campaigners after it was acquired by US food group Kraft in 2010, engaged in aggressive tax avoidance schemes before the takeover that were designed to slash its UK tax bill by more than a third.

A Financial Times investigation into the tax affairs of the company – established in 1824 by Quakers and known for its philanthropic ethos – has uncovered tax avoidance schemes former senior executives admit were “highly aggressive”.

.....

Like many multinationals, Cadbury reduced its corporation tax bill by loading operations in high tax countries, such as the UK and US, with debt, while using equity to fund its growth through low tax jurisdictions such as Ireland.

But it went even further by devising schemes to engineer interest charges that could be deducted from its gross profits and reduce UK tax.

     And the New York Times Deal Book recently published an article on the increased use of international mergers as a way to cut corporate tax bills:

From New York to Silicon Valley, more and more large American corporations are reducing their tax bill by buying a foreign company and effectively renouncing their United States citizenship.

“It’s almost like the holy grail,” said Andrew M. Short, a partner in the tax department of Paul Hastings, which advises a number of American corporations on deals. “We spend all of our time working for multinationals, thinking about how we’re going to expand their business internationally and keep the taxation of those activities offshore,” he added.

Reincorporating in low-tax havens like Bermuda, the Cayman Islands or Ireland — known as “inversions” — has been going on for decades. But as regulation has made the process more onerous over the years, companies can no longer simply open a new office abroad or move to a country where they already do substantial business.

Instead, most inversions today are achieved through multibillion-dollar cross-border mergers and acquisitions. Robert Willens, a corporate tax adviser, estimates there have been about 50 inversions over all. Of those, 20 occurred in the last year and a half, and most of those were done through mergers.