The impact of the Tax Cuts and Jobs Act (TCJA) was particularly significant in the cross-border context, where taxpayers and practitioners saw drastic changes come into effect almost overnight. One of the most disruptive and wide-reaching changes was the repeal of Section 958(b)(4), which historically had prevented the downward attribution of stock from foreign persons to U.S. entities in the context of the U.S. controlled foreign corporation (CFC) provisions. This limitation, which was included in the original CFC legislation that came into effect in 1962, essentially meant that a corporation would not be classified as a CFC solely on the basis of stock attribution from foreign persons to U.S. persons. This sensible approach was eliminated with the repeal of Section 958(b)(4); this action was reportedly intended to combat certain narrow decontrolling CFC transactions in connection with corporate inversions. In a clear example of using a sledgehammer to kill a fly, and apparently to the surprise of Congress and the U.S. tax authorities, the change created thousands of unintended constructive CFCs. And importantly, unlike most other provisions of the TCJA, the repeal of Section 958(b)(4) was made retroactive to 2017, further aggravating the adverse impacts of the change upon those affected.

Background on CFC Standards and Attribution Rules

Under the U.S. tax system generally, shareholders of corporations typically are not taxable on corporate income unless and until a distribution is made from the corporation or the shareholder disposes of the relevant shares. However, since 1962, if a foreign corporation is classified as a CFC, certain income of the corporation is taxable to the corporation's U.S. shareholders annually, whether or not any distribution or disposal occurs. Until 2018, only "Subpart F income" of CFCs, generally consisting of passive income and income from certain related party transactions, was subject to these anti-deferral provisions. Beginning in tax year 2018, in a shift toward the growing international push for a global minimum tax, new rules under the TCJA also brought most active business income [confusingly dubbed "global intangible low-taxed income" (GILTI), though not limited to income connected to intangibles] into the scope of the anti-deferral rules applicable to U.S. shareholders of CFCs.

In order for the above-referenced CFC provisions to apply and result in current U.S. taxation, there must be both a CFC and at least one "U.S. shareholder," an individual, corporation, partnership, trust or estate owning 10% or more of the corporation's stock (again by vote or value) either directly, indirectly or constructively. A CFC is a foreign corporation that is more than 50% owned (by vote or value) directly, indirectly, or constructively by U.S. shareholders. Importantly, tax is never imposed under these rules on a constructive basis; rather, a taxable U.S. shareholder generally is subject to tax on the CFC's Subpart F income or GILTI only if the shareholder directly or indirectly meets the 10% ownership threshold.

To determine constructive ownership for the CFC and U.S. shareholder standards, the CFC rules have always incorporated Section 318 principles, with certain important modifications; thus, attribution can occur between family members or entities, as well as between individuals and entities. The modifications specific to the CFC context are found in Section 958(b), which provides, among other things, that there is no family attribution from a nonresident alien to a U.S. person, and, prior to the TCJA's repeal of Section 958(b)(4), that downward attribution under Section 318(a)(3) did not apply to attribute stock from a foreign person to a U.S. entity.

Prior to repeal, Section 958(b)(4) thus prevented CFC classification in the following case. Assume foreign corporation U wholly owned two subsidiary corporations—corporation W, a foreign corporation, and corporation V, a domestic corporation. The general attribution rules under Section 318(a)(3)(C) would require U's shares of W to be attributed downward to V, such that V was the constructive owner of W, triggering CFC classification as to W. However, Section 958(b)(4) prevented this result by prohibiting attribution from U, a foreign person, to V, a domestic entity.  Consequently, while Section 958(b)(4) remained law, V was not a U.S. shareholder and W was not a CFC (Pre-TCJA Treas. Reg. Section 1.958-2(g), Example 4). After the repeal of Section 958(b)(4), the foregoing regulatory example was revised to conclude that V is a U.S. shareholder, and therefore W is a CFC (Treas. Reg. Section 1.958-2(g), Example 4).

Repeal of Section 958(b)(4)

The conference agreement notes that the repeal of this provision was meant to render ineffective certain transactions that are used as a means to avoid Subpart F. To say it did much more than that would be a gross understatement.

The repeal was made effective for the last taxable year of a foreign corporation beginning before January 1, 2018. The relevant legislative history further clarifies that repeal was not intended to create a CFC with respect to a U.S. shareholder where the U.S. shareholder is not related [within the meaning of Section 954(d)(3)] to the U.S. person to whom stock is attributed [H.R. Conf. Rep't 115-466, 115th Cong., 1st Sess. p. 633 (Dec. 15, 2017)]. The standard for relatedness under Section 954(d)(3) means more than 50% vote or value for a corporation, or more than 50% value for a partnership, trust or estate. Despite reflecting this issue in the historical record, Congress apparently believed that the intent already was clear and therefore an amendment codifying it was unnecessary, so the statute contains no appropriate limiting or clarifying language.

This creates real difficulties for taxpayers and planners, because the statute on its face is clear and unqualified. For this reason, Treasury and IRS also have been reluctant to act to significantly narrow the scope of the change, believing they lack the authority to do so. Instead, through various regulatory packages, they have narrowed the impact of repeal in only very specific fact patterns and contexts, many of which work in the government's favor rather than that of taxpayers.

Discussion of Specific Examples

As noted above, U.S. shareholders are taxed only on the basis of direct and indirect ownership interests in a CFC. At first glance, this might lead observers to conclude that a constructive CFC is harmless as long as there is no U.S. shareholder owning, directly or indirectly, the requisite 10%. Although in some cases this may end up being accurate, in many others CFC classification clearly harms taxpayers who are outside the intended scope of the change. First, an entity that was not previously a CFC but with respect to which one or more U.S. persons did hold (directly or indirectly) 10% or more of the foreign corporation's stock, the conversion of the non-CFC entity into a CFC means that these 10% owners are now subject to annual U.S. tax on their shares of Subpart F income and GILTI. Additionally, the increased constructive ownership resulting from attributing additional stock from foreign persons to U.S. entities is relevant to a number of tax provisions other than Sections 951 and 951A. 

For example, Section 954(c)(6) contains a look-through rule that causes certain non-Subpart F income of a CFC, when paid to a related CFC, to retain its character as non-Subpart F income. The benefits of this provision to taxpayers would be expanded by increasing the "relatedness" of CFCs in many cases as a result of Section 958(b)(4) repeal. Recent regulations at Section 1.954-1(f)(2)(iv) eliminate this expansion by turning off the downward attribution rules under Section 318(a)(3) to determine whether two parties are related under Section 954(d)(3). As a result, Section 954(c)(6) benefits are not available to CFCs that are "related" only on a constructive basis. On the other hand, this same regulation actually helps taxpayers minimize the risk of generating Subpart F income under Sections 954(d) and (e), as it makes it less likely that two CFCs would be considered related for purposes of these provisions.

Separately, consider a structure in which a foreign parent corporation owned by non-U.S. persons holds two subsidiary corporations—US Sub and Foreign Sub. Assume Foreign Sub owns a U.S. holding corporation (US Holdco), which in turn owns two U.S. operating subsidiary corporations. After the repeal of Section 958(b)(4), Foreign Sub is clearly a CFC based on constructive ownership by US Sub. If US Holdco liquidates into Foreign Sub, Section 332(d)(3) generally would cause Foreign Sub, a CFC, to realize gain under Section 331 that would be recognized by its U.S. shareholders as Subpart F income. In this example, because there are no taxable U.S. shareholders, no U.S. tax would be collected. In response to this concern, Treasury promulgated regulations that disregard the downward attribution rules in this specific context, which has the general effect of causing the liquidating distribution to be subject to a 30% U.S. withholding tax (Treas. Reg. Section 1.332-8).

Finally, an area that has received much warranted attention from taxpayers and advisors is the impact of this change on typical inbound portfolio debt structures. Congress made a conscious decision in the 1980s to encourage inbound lending by providing certain tax advantages to such debt, compared with a similar inbound equity investment.  Specifically, the portfolio interest exemption under Sections 881(c) and 871(h) provides that a loan from a non-U.S. lender to a U.S. person generally is exempt from the usual 30% U.S. withholding tax. Exceptions to this exemption apply where the lender is a 10% shareholder as to the borrower (for corporate borrowers, this standard looks only to voting power) or where the lender is a CFC that is “related” to the borrower. In most such inbound lending structures, which are routinely used to raise funding abroad that is then invested in U.S. development, there are no direct or indirect 10% U.S. shareholders to whom the Subpart F or GILTI rules would apply. But the impact of CFC classification in these cases, where the lending entity may now technically be a CFC based on constructive ownership, is to cause interest payments that have historically been exempt from U.S. tax to instead be taxed on a gross basis at 30%. The carve-out in Section 881(c)(3)(C) for certain interest received by CFCs is thus exponentially more impactful after the repeal of Section 958(b)(4), and trade groups and commentators have repeatedly pleaded with Treasury, IRS, and increasingly, Congress to provide relief. There is no indication that this particular issue was ever identified or considered by Congress during the discussions leading up to repeal. And so far, while Treasury and IRS have acted to narrow the scope of repeal in certain specific areas, they have refused to do so in this area, and have indicated they believe Congressional action is needed. Several proposals have been advanced to do just this [see, e.g., Sec. 2209 of Senate bill to CARES Act; S. 2589; and H.R. 4509 (2019)], but none of them has become law.

Potential Solutions

The need for a legislative fix has already been suggested above, and many are hopeful that one eventually will arrive, though it is impossible to know with certainty. In the meantime, a very case-by-case approach generally is needed to determine how to best react to the many issues having a constructive CFC may create. In the portfolio interest context, for example, many used check-the-box elections to treat their foreign lending companies as partnerships, rather than corporations, to take them out of the potential scope of CFC classification. This created a compliance nightmare for many though, particularly in the context of large private equity structures, where the U.S. borrower (typically a U.S. corporation) was consequently forced to issue an incredible number of Forms 1042-S and disclose the identities of its indirect foreign owners, which is not something most foreign investors are comfortable with. For these reasons, this was not a terribly practical work-around.  

There is also an argument to be made based on the Congressional Record, where it was clearly stated that repeal was not intended to create a CFC with respect to a U.S. shareholder where the shareholder is not related [within the meaning of Section 954(d)(3)] to the U.S. person to whom stock is attributed. Particularly where partnerships are involved, for example, because there is no de minimis threshold for attribution downward to a partnership [i.e., if I own 1% of a U.S. partnership, 100% of the stock I own in other entities is attributed to the partnership under Section 318(a)(3)(A)], the CFC consequence is often nothing short of absurd. A foreign individual owning 51% of a foreign corporation, and separately owning an unrelated 1% interest in a U.S. partnership, arguably triggers CFC classification as to the foreign corporation because all 51% of the foreign corporation stock is attributed down to the U.S. partnership. In such cases, it seems reasonable for advisors to rely upon the above language from the legislative history, by extension, to argue that the foreign corporation should not be a CFC given that the foreign individual (who is clearly not a U.S. shareholder) is not related [based on the more than 50% standard under Section 954(d)(3)] to the U.S. partnership to whom the interests would be attributed. On the other hand, this argument on its face conflicts with the statute.

Conclusion

In the absence of Congressional action or other future guidance, taxpayers and their advisors are left to navigate a seemingly clear statute that produces completely unreasonable results in many cases, and to restructure historic planning recommendations in an effort to protect themselves and their clients, or to rely on policy and legislative history-based arguments that do not provide certainty to anyone.     

Summer A. LePree, Esq., JD, LLM (Taxation), is a partner in Baker McKenzie's Tax Practice Group. Summer’s practice is focused on advising US and foreign-based public and private companies in connection with their inbound and outbound US international tax planning. She constantly monitors developments in US and global tax laws, and thoughtfully advises clients on the relevant implications to their businesses. Summer regularly assists clients with Subpart F, GILTI, and FDII planning, FIRPTA issues, treaty planning and analysis, and overall structuring for tax optimization. Summer is a go-to lawyer for clients who need sophisticated, creative, international tax counsel. Summer is a frequent speaker and author on a variety of cross-border income tax issues, is actively involved in the ABA Tax Section, where she currently serves as the Council Director for the International Committees, and teaches as an adjunct professor for the graduate tax programs at the University of Florida and the University of Miami Law Schools. She can be reached at summer.lepree@bakermckenzie.com.

Jeffrey L. Rubinger, JD, LLM (Taxation), CPA (inactive), is a partner in Baker McKenzie's Tax Practice Group.  A skilled legal practitioner with more than 20 years of international tax experience, he also served for many years as a CPA at a major accounting firm, giving him a unique and thorough understanding of the business issues his clients face every day. Jeff has been recognized as one of America's leading tax lawyers by Chambers USA. Jeff is known worldwide as the lawyer to seek out when companies require a creative, sophisticated solution to a complex international tax situation. From US companies expanding overseas to foreign businesses investing in the United States, clients turn to Jeff for his extensive knowledge of the tax laws in a wide variety of jurisdictions, including countries in South America, Europe, Asia, and the Middle East. Jeff is distinctive in Florida for his significant experience with outbound matters. He can be reached at Jeff.Rubinger@bakermckenzie.com.