International Tax Blog

Bulgarian Aktsionerno Druzhestvo Added To Per Se Corporation List

On March 20, 2008, the Treasury Department published Treasury Decision 9388.  The T.D. updated the per se corporation list to include Bulgarian aktsionerno druzhestvos.  The per se corporation list already includes a Societas Europaea or SE.  See Treas. Reg. § 301.7701-2(b)(8).

With respect to many issues, EU regulations defer to the laws of the country in which the SE has its registered office.  An SE must have a registered office in one of the Member States of the European Economic Area, which includes Norway, Iceland, Liechtenstein, and every country in the European Union.  With the entry of Bulgaria into the European Union on January 1, 2007, an SE can now have its registered office in Bulgaria.

Bulgaria's SE is called an aktsionerno druzhestvo.  The IRS and the Treasury Department stated in Notice 2007-10 that Treas. Reg. § 301.7701-2(b)(8) would be modified to include the aktsionerno druzhestvo on the per se corporation list.  The temporary regulations in T.D. 9388 make that modification.

Inheriting Foreign Real Estate Inside a Foreign Corporation

In many countries, real estate is commonly owned through entities with limited liability, such as corporations and limited companies.  If a U.S. person inherits the stock of a foreign corporation from a non-U.S. person, or from another U.S. person, the U.S. tax costs related to the disposition of the underlying real estate can be much greater than most taxpayers and tax professionals would expect.

As a preliminary matter, it is important to file the appropriate U.S. tax forms to disclose the receipt of an inheritance from a non-U.S. person.  Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, must be filed by U.S. persons that receive foreign inheritances of $100,000 or more.  Failure to file Form 3520 to report the inheritance can result in a penalty of 5% of the amount of the inheritance for each month that the failure to report continues (not to exceed a total of 25%).  See Code § 6039F(c).

The following example demonstrates the U.S. tax ramifications of a U.S. person inheriting stock in a foreign corporation that owns foreign real estate.  Assume the following facts:

Individual A is a U.S. resident or U.S. citizen.  Individual A’s father (“Father”) is not, and has never been, a U.S. resident or U.S. citizen.  Prior to his demise, Father’s only asset is stock in a foreign corporation (“FC”).  FC was formed years ago when Father had contributed $100,000 into FC in exchange for FC stock.  FC used the cash to purchase undeveloped real estate in a foreign country.

Father dies and leaves his sole asset (stock in FC) to his only child, Individual A.  The real estate owned by FC has substantially appreciated since FC purchased it years before.  The fair market value of the real estate held by FC at the time of Father’s death is $1,000,000 and the fair market value of the stock of FC is also $1,000,000.

Three months after Individual A inherits the stock of FC, FC sells the foreign real estate for $1,000,000 and distributes the cash of $1,000,000 to Individual A in liquidation of FC.  For simplicity, this example assumes that there are no transaction-related costs on the sale and that there are no foreign income taxes imposed on the sale.

For U.S. tax purposes, Individual A will receive a tax basis in the stock of FC equal to the fair market value of the stock at the date of Father’s death ($1,000,000).  Code § 1014(a).  This is often referred to as a “stepped up” tax basis.  FC’s tax basis in the foreign real estate, however, remains equal to FC’s original cost of the real estate ($100,000).  When FC sells the foreign real estate, for U.S. tax purposes, a gain of $900,000 will be recognized by FC.

When Individual A inherits 100% of the stock of FC, FC will become a controlled foreign corporation (“CFC”).  Code § 957(a).  As a U.S. shareholder of a CFC, Individual A will be required to file Form 5471, Information Return of U.S. Person With Respect to Certain Foreign Corporations, for FC.  See Code §§ 6038 and 6046.

Certain income of CFCs is treated as an inclusion in income of the CFC’s U.S. shareholders (similar to a “deemed” dividend), even if no cash or other property is actually distributed out of the CFC.  Such income is known as “subpart F income.”  The $900,000 gain recognized by FC on its sale of the undeveloped foreign real estate would be considered subpart F income.  Code § 954(c)(1)(B)(iii).  Thus, Individual A will have an inclusion in income of $900,000.  This inclusion will be treated as ordinary income and will not qualify for the maximum 15% rate on dividend income, even if FC is located in a country that has a comprehensive income tax treaty with the U.S.  See Notice 2004-70.

Thus, even though the fair market value of the FC stock was $1,000,000 and Individual A’s tax basis in the stock of FC was $1,000,000, Individual A will recognize ordinary income of $900,000.  Under Code § 961(a), Individual A will receive an increase in his/her tax basis in the stock of FC as a result of the recognition of the subpart F income.  This increase in basis is generally intended to prevent double taxation of the same income.  Thus, Individual A will increase his/her tax basis in the stock of FC from $1,000,000 to $1,900,000.

The liquidation of FC will be treated as a sale or exchange of the stock of FC by Individual A in exchange for the $1,000,000 received.  Code § 331(a).  Individual A’s proceeds will equal $1,000,000 and his/her basis in the stock will be $1,900,000.  Thus, Individual A will recognize a loss on the liquidation equal to $900,000.  Although Individual A and FC are treated as related parties, and losses on sales or exchanges between related parties are generally disallowed, an exception applies for distributions in corporate liquidations.  Treas. Reg. § 1.267(a)-1.

If the subpart F income and the loss on the liquidation were both treated as ordinary income/loss, or both treated as capital gain/loss, then the income of $900,000 would be offset by the loss of $900,000.  However, because the subpart F income is ordinary income and the loss on the liquidation is a capital loss, the two cannot be directly offset.  Instead, the subpart F income will be included in income in its entirety but, the capital loss will be subject to restrictions on the amount that can be deducted.  If Individual A has no capital gains during the year, then he/she will only be able to deduct $3,000 of the $900,000 capital loss.

The net result of these transactions is that Individual A will recognize ordinary taxable income during the year of $897,000 and will have a capital loss carryforward of $897,000 that can be used in future years (subject to the annual limitation of $3,000, plus capital gains).  This result typically comes as a huge surprise to taxpayers and tax practitioners alike.

There are certain tax planning strategies that can be implemented to avoid this unexpected and uneconomic result.  However, some strategies require that steps be taken soon after the stock is inherited.  Other strategies can be implemented at a later date, but almost certainly require that steps be taken before the property is sold.  Thus, if a U.S. person inherits foreign real estate in a foreign corporation, it is important to contact an international tax advisor as soon as possible.

U.S. Competitiveness and Corporate Tax Rates

The Tax Foundation recently published a report that compares the U.S. corporate income tax rate with corporate income tax rates of various developed countries.  The report, titled "U.S. States Lead the World in High Corporate Taxes," indicates that the U.S. average combined federal and state corporate income tax rate is over 39%.  By comparison, Sweden, Norway, and Finland have corporate income tax rates of 28%, 28%, and 26%, respectively.  These rates are much lower than the U.S. rate.  The results of this report might lead one to believe that the U.S. has one of the highest overall tax rates in the world.

Can this be true?  Is the U.S. really so UNcompetitive from a tax perspective?

In short, no.  Corporate income taxes are only one type of tax imposed.  Various other types of taxes exist.  For instance, many other countries impose a value added tax ("VAT").  The U.S. does not impose a VAT.  If the U.S. federal government were to impose a VAT, it is likely that it could raise sufficient revenue to significantly reduce (or possibly even eliminate) the federal corporate income tax rate.  This is not to say that the U.S. should impose a VAT.  Instead, it is merely stating that comparing solely corporate income tax rates among countries can be an "apples to oranges" comparison.

A better measure, perhaps, to consider tax competitiveness would be total taxes raised as a percentage of gross domestic product ("GDP").   In 2003, the U.S. raised total tax revenue of 25% of GDP.  In contrast, the countries of Sweden, Norway, and Finland raised total tax revenue as a percent of GDP of 51%, 44%, and 45%, respectively.  See OECD Report.  This statistic would imply that the U.S. is in fact a very competitive jurisdiction from a tax perspective.

Electronic Arts Chart

We recently uploaded a chart of the Electronic Arts case that partially deals with the manufacturing exception for foreign base company sales income.  The chart can be found at Electronic Arts.  The Tax Court in Electronic Arts did not analyze in detail Treas. Reg. § 1.954-3(a)(4).  The case was a motion for summary judgment that dealt with both Code §§ 954 and 936.  The rules under these two sections may not have been perfectly in accord with each other.  In the opinion, the Tax Court stated:

petitioner's focus on certain language in section 1.954-3(a)(4), Income Tax Regs., overlooks the regulation's requirement that various actions have been done `by' the corporation being evaluated.

By "various actions," the Tax Court seems to mean "manufacturing."  Thus, "manufactruing" must be done by the corporation.  In the Electronic Arts case, it appeared that Electronic Arts Puerto Rico ("EAPR") legally and beneficially owned the raw materials, the work in process, and the finished products all throughout the manufacturing process.  It also appeared that that product purchased was substantially transformed prior to its sale.  A literal reading of Treas. Reg. § 1.954-3(a)(4) would lead one to believe that EAPR "manufactured" and that the product should have been treated as manufactured "by" EAPR.

The Foreign Base Company Sales Income “Manufacturing Exception”

Code § 954(d)(1) defines foreign base company sales as follows:

[T]he term "foreign base company sales income" means 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 where --

(A) the property which is purchased (or in the case of property sold on behalf of a related person, the property which is sold) is manufactured, produced, grown, or extracted outside the country under the laws of which the controlled foreign corporation is created or organized, and

(B) the property is sold for use, consumption, or disposition outside such foreign country, or, in the case of property purchased on behalf of a related person, is purchased for use, consumption, or disposition outside such foreign country.

Code § 954(d)(2) provides special rules for controlled foreign corporations that carry on activities through a branch or similar establishment outside the country of incorporation of the controlled foreign corporation.  This posting does not deal with the special branch rules of Code § 954(d)(2).  Instead, here the focus is on a controlled foreign corporation that carries on all of its activities in one country.

Treas. Reg. § 1.954-3(a)(1) generally defines foreign base company sales income (“FBCSI”).  Treas. Reg. § 1.954-(a)(2) goes on to provide that FBCSI:

does not include income derived in connection with the purchase and sale of personal property . . . if the property is manufactured . . . in the country under the laws of which the controlled foreign corporation . . . is created or organized.  See section 954(d)(1)(A).

Treas. Reg. § 1.954-(a)(3) further provides that FBCSI:

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 . . . is created or organized . . . See section 954(d)(1)(B).

The exceptions in Treas. Reg. § 1.954-3(a)(2) and (a)(3) directly mirror the statute in Code § 954(d)(1)(A) and (d)(1)(B).  It is interesting to note that Code § 954(d)(1)(B) and Treas. Reg. § 1.954-3(a)(3) have no relation to where the personal property was manufactured or by whom it was manufactured.  Further, Code § 954(d)(1)(A) and Treas. Reg. § 1.954-3(a)(2) only refer to where the personal property was manufactured.  Under these rules, there is no need to determine who manufactured the personal property.

Up to this point, the statute and the regulations are parallel to each other.  However, Treas. Reg. § 1.954-3(a)(4) provides an exception to FBCSI that is not explicitly provided for in the statute.  Treas. Reg. § 1.954-3(a)(4)(i) provides that FBCSI:

does not include income of a controlled foreign corporation derived in connection with the sale of personal property manufactured . . . by such corporation . . . .

As mentioned above, the statute has no explicit parallel to this rule in the regulations.  Nowhere in Code § 954(d) does it state that property manufactured by a corporation will be excluded from FBCSI.  The legislative history of Code § 954(d) does, however, refer to an exception for property manufactured “by the selling corporation.”  Thus, Treas. Reg. § 1.954-3(a)(4) would appear to be consistent with the intent of Congress.

If one attempts to discern where in the language of the statute this “manufacturing” exception could be embodied, it makes sense to focus on the language “income . . . derived in connection with the purchase of personal property . . . and its sale . . . .”  This reliance appears to be supported by Treas. Reg. § 1.954-3(a)(4)(i), which provides that:

A foreign corporation will be considered . . . to have manufactured . . . personal property which it sells if the property sold is in effect not the property which it purchased.  In the case of the manufacture . . . of personal property, the property sold will be considered . . . as not being the property which is purchased if the provisions of subdivision (ii) or (iii) of this subparagraph are satisfied.

Thus, under certain circumstances, a foreign corporation is considered to have manufactured.  If a foreign corporation is considered to have manufactured, it would seem to follow that the manufacturing would be considered done “by the corporation.”  It would be a non sequitur to state that a foreign corporation is considered to have manufactured a product, but that the product was not considered manufactured by the corporation.

The Internal Revenue Service and the Treasury Department recently published proposed regulations (see here) which would amend Treas. Reg. § 1.954-3.  The following is an excerpt from the preamble to those proposed regulations:

Section 954(d)(1) includes, as FBCSI, income from the purchase of personal property from any person and “its” sale to a related person.  Some taxpayers argue that use of the word “its” implies that the property sold must be the same property that is purchased for the sales income to be FBCSI.  Accordingly, these taxpayers assert that where the personal property purchased by the CFC is manufactured such that the property purchased is not the same as the property sold by the CFC, the property sold by the CFC is not the property purchased and therefore the sale of such property does not generate FBCSI, even if the CFC itself performs little or no part of the manufacture of that property.

The preamble to the regulations goes on to state that “[t]he Treasury Department and the IRS believe that the position taken by these taxpayers is contrary to existing law, and results from an incorrect reading of section 954(d)(1) and Sec.  1.954-3(a)(4)(i).”

It is submitted here that the Treasury Department, when drafting the original regulations under Code § 954(d), themselves relied on the use of the word “its” (in the same manner as taxpayers may be relying on the use of the word "its") to arrive at the manufacturing exception provided in Treas. Reg. § 1.954-3(a)(4).  Otherwise, it is unclear what language in the statute the Treasury Department relied upon to allow for the manufacturing exception in Treas. Reg. § 1.954-3(a)(4).

Third Circuit Reverses Tax Court in Swallows Holdings

The Third Circuit Court of Appeals recently reversed the Tax Court’s decision in Swallows Holdings Ltd v. Commissioner, 126 T.C. 96 (2006).  The Tax Court had held that Treas. Reg. § 1.882-4(a)(3)(i) was invalid.

Treas. Reg. § 1.882-4(a)(3)(i) requires that a foreign corporation file a return within eighteen months of the filing deadline set in Code § 6072 in order for the corporation to be able to claim deductions.  In Swallows, the taxpayer filed the tax returns in question well after the expiration of the eighteen-month filing period.

The Third Circuit held that the Tax Court erred in applying the six factors provided in National Muffler Dealers Association v. United States, 440 U.S. 472, 477 (1979), to the extent that the National Muffler factors are inconsistent with the standard established in Chevron U.S.A., Inc. v. Natural Resources Defense Counsel, Inc., 467 U.S. 837 (1984).

The Third Circuit stated that:

The Secretary will, under the current regulation, allow a foreign company to file eighteen months after the filing was originally due.  Moreover, because I.R.C. § 6072(c) already provides for a five and one-half month filing period, foreign companies have, in practice, twenty-three and one-half months to submit a “timely” return.  It is not unreasonable for the Secretary to impose such a deadline.

Thus, Treas. Reg. § 1.882-4(a)(3)(i) continues to be a valid regulation.

Foreign Vacation Homes & Rental Properties

U.S. residents with foreign vacation homes and foreign rental properties may unwittingly be subject to U.S. tax on interest paid to foreign banks.  A 30% tax is imposed on U.S. source interest received by foreign corporations.  Code § 881(a)(1).  Interest is sourced in the U.S. if the obligor is resident in the U.S.  Code § 861(a) provides:

The following items . . . shall be treated as income from sources within the United States . . . . (1) Interest from . . . obligations of noncorporate residents . . . .

Although the tax is technically imposed on the foreign lender, the person making the payment is required to withhold the 30% tax and can also be held liable for the tax.  Code §§ 1441, 1442, and 1461. U.S. citizens and aliens residing in the U.S. that have borrowed to purchase real estate outside the U.S. are typically astonished to learn that this tax exists, and that they can be held liable for the tax.

• This is not a purely theoretical matter.  In Housden v. Commissioner, 63 TCM 2063 (1992), a U.S. resident individual had existing loans from a Canadian bank prior to moving to the U.S.  After he moved to the U.S., he continued to make payments on the loans from the Canadian bank.  The Tax Court held that he was liable for the withholding tax.  For a chart of this case, see Housden.

Income tax treaties between the U.S. and foreign countries typically reduce the withholding tax rate.  However, if you want to rely on the treaty, you need to obtain a Form W-8BEN, Certification of Foreign Status of Beneficial Owner for United States Tax Withholding, from the foreign bank where the bank certifies that it qualifies for treaty benefits.  Regardless of whether a lower treaty rate applies, Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons (and Form 1042-S) must be filed to report the interest payments to foreign persons.

For U.S. citizens residing outside the U.S., this tax does not apply.  As indicated above, sourcing is based on the residence of the obligor.  Thus, if a U.S. citizen resides outside the U.S., the interest will be foreign source income and there will be no withholding tax.

If the foreign lender is not a bank, it may be possible to structure the loan in a way that avoids the tax under the "portfolio interest exception."  Code §§ 871(h) and 881(c).  However, banks acting in the ordinary course of business cannot qualify for the portfolio interest exception.  Code § 881(c)(3)(A).

Practitioner Cross-Border Activities Can be Costly

In a recent tax bulletin board posting, a tax preparer revealed that they had been designated as a resident agent for a foreign corporation.  After alerting the foreign corporation of the U.S. tax filing requirements, the foreign corporation terminated the relationship.  However, the tax preparer was never removed as the resident agent of the foreign corporation.  The Florida tax authorities then issued a summons to the resident agent, since the foreign corporation did not pay its taxes.  The taxes due were listed in the millions of dollars.

This is but one example of how getting involved in cross-border activities can be costly to tax preparers.  More typically, tax preparers that have not dealt with international operations often are unware of the various U.S. tax filing requirements related to cross-border activities.  The potential penalties for simply failing to report the existence of cross-border transactions can be amazingly large.

Tax practitioners should make certain they are prepared to delve into international waters prior to making the plunge.  The tax bulletin board link can be found at cross-border dangers.