IRS Moves To Limit Certain Foreign Tax Planning

IRS Moves To Limit Certain Foreign Tax Planning

December 01, 1999

The Internal Revenue Service proposed changes in its “check-the-box” regulations on November 26 that would rule out two foreign tax planning techniques that have been used by the project finance community.

The changes will not take effect in theory until the IRS republishes them in final form — perhaps in late 2000. However, the IRS said in a technical assistance memorandum in September that it does not believe one of the techniques works under existing law.

The “check-the-box” regulations are a set of rules that let US companies decide how they want their foreign subsidiaries classified for US tax purposes simply by checking a box on an IRS form. There are three choices: corporation, partnership or “disregarded entity,” meaning the subsidiary does not exist at all for US tax purposes. US companies have had a much easier time —since the check-the-box rules took effect in January 1997 — structuring foreign investments so that US taxes on the earnings can be deferred. The earnings have to be retained offshore.

The IRS was uneasy from the start about what US companies and their tax advisers might be able to do. Soon after the rules were published, the IRS learned that US multinationals were using the ability to treat foreign subsidiaries as disregarded as a tool to “strip” earnings from foreign countries with little or no tax and, at the same time, defer US taxes on the earnings. The IRS tried in Notice 98-11 in early 1998 to put a stop to the practice. However, Congress forced the IRS to back down after heavy lobbying by US industry. Enforcement of the IRS rules on earnings stripping has now been delayed until July 1, 2005 at the earliest.

The IRS now wants to block two more tax planning techniques.

Sales of Shares

In one, a US company checks the box to cause a foreign subsidiary to disappear for US tax purposes shortly before shares in the subsidiary are sold. Gain from the sale of shares is “subpart F income,” meaning income on which it is impossible to defer US taxes. Therefore, the US company files an election before the sale to treat the foreign subsidiary as disregarded. This means that the sale is treated as a sale of the foreign subsidiary’s assets. Gain from the sale of assets ordinarily is not subpart F income.

The IRS said in a technical assistance memorandum released in September that a US company cannot avoid subpart F income on its gain by making a last-minute election. According to it, gain from the sale of assets escapes being labeled “subpart F income” only if the seller used the assets in its trade or business for more than half the period it held them. The IRS said that when a parent company becomes the owner of assets by checking the box on a subsidiary, it does so for the purpose of selling the assets and not using them in a trade or business. One commentator remarked wryly, “The Service would seem not to like its check-the-box regulations as they apparently might be used in certain situations.”

The latest IRS action proposes to amend the check-the-box regulations.

Under the proposed rule, a US company would not be able to change the classification of any foreign subsidiary from corporation to disregarded entity within 12 months before a sale of 10% or more of the shares in the subsidiary.

Shelf Companies

The IRS also said it would not allow “shelf” companies to be used to get around this rule. It gave the following example. A parent company owns two foreign subsidiaries, FC1 and FC2. FC1 is a real company with real assets and is a corporation for US tax purposes. FC2 is a shelf company that was formed two years ago, has no assets, and is treated as disregarded. The parent merges FC1 into FC2 with FC2 as the surviving company and then sells shares in FC2, hoping to treat a gain or loss from the sale of FC2 shares as from the sale of FC1 assets.

Under the proposed new rules, the IRS would reclassify FC2 as a corporation. It said it would do this whenever a disregarded foreign entity with few assets acquires the assets of another foreign entity in a transaction that is at least partly tax free and then, within 12 months, at least 10% of the shares in FC2 are sold.

What is a shelf company? The IRS proposes an 80% test. If the assets acquired by FC2 comprise more than 80% of FC2’s assets after the acquisition or merger, then the proposed rule will come into play.

The IRS said it would apply an “anti-stuffing rule.” It would not allow cash and marketable securities that “exceed the reasonable needs” of FC2 to be stuffed into FC2 to avoid characterization as a shelf company.

A problem with bright-line tests like these is they encourage more planning to get around them. If Congress would permit it, the IRS would be better off with a general statement of principles. US companies would be able to avoid the new rules by planning ahead in future. An election to treat a subsidiary as disregarded could be made at least 12 months before sale of the subsidiary. If a shelf company will be used, then one could plan ahead in the sense of having real assets other than cash or marketable securities in the shelf company before the merger.

“Grandfathered” Partnerships

The IRS also said it is offended by trafficking in foreign companies that were formed before the check-the-box regime took effect in January 1997 and that are classified under a “grandfather” rule as partnerships.

These entities have value because the IRS issued a list of per se corporations in January 1997. These are types of entities — generally one per country — that are treated automatically as corporations. US companies generally prefer not to have their foreign subsidiaries classified as corporations because this makes it harder to defer US taxes. Thus, for example, if a US company needed a subsidiary in Latin America and is required to use a sociedad anonime, or “SA” — which is a per se corporation — it might acquire an SA from someone else that was classified as a partnership for US tax purposes before January 1997. Such an SA can continue to be classified as a partnership under a grandfather rule.

The IRS proposes to revoke the grandfathered status of such entities if there is at least a 50% change in ownership after November 29, 1999.

The entity would already lose its grandfathered status under the existing IRS regulations if there is a “sale or exchange” of at least a 50% interest in the entity’s capital and profits within any 12-month period. The new proposal is aimed at preventing tax planning around this rule.

Per Se List

The IRS also finalized some changes to the per se corporations list on November 26. These changes had been proposed earlier.

The main changes are clarifications that a sociedad anonime de capital variable, or an SA de CV, formed in Mexico is a per se corporation and that companies “limited by shares” or “limited by guarantee” are considered “limited companies” in countries where a “limited company” is a per se corporation. These changes are retroactive to January 1, 1997. The IRS also made minor changes to the companies listed for Canada, Cyprus, Finland, Hong Kong, Jamaica, Malta, Norway and Trinidad and Tobago.

by Keith Martin, in Washington