While interest received by a CFC is normally Subpart F income (which means it is classified as foreign personal holding company income), in this case the “same country” exception found in Section 954(c)(3) of the tax code would apply to exclude the interest from designation as Subpart F income.1
However, if Branch-1 were considered to be a CFC, the payment of interest would be between CFCs located in different countries and, thus Subpart F income would arise.
Accordingly, if the check-the-box rules are used, Branch-1 is disregarded, and CFC-1 will have lowered its foreign tax on deferred income and created a significant tax incentive to invest abroad. Accordingly, since this arrangement creates income intended to be Subpart F income which is not subject to Subpart F, the result of the arrangement is “inconsistent with the policies and rules of Subpart F.”
The second example contained in Notice 98-11 is virtually identical to the one President Obama recounted in his speech on May 4, 2009, in which he introduced his initiatives. There, CFC-3 is incorporated in Alpha and CFC-3 has a branch (Branch-2) in country Beta.
Once again, the tax laws of each such country classify CFC-3 and Branch-2 as separate entities. Branch-2 makes a loan to CFC-3 and the latter, which earns only non-Subpart F income, pays interest to Branch-2 that Alpha allows as a tax deduction. Little or no tax is paid by Branch-2 on the receipt of interest.
The example notes that if Branch-2 is disregarded, in accordance with the check-the-box rules, U.S. tax law would not recognize the “income flows.” After all, a corporation cannot make a loan to, and pay interest to, itself. By contrast, if this transaction was between two CFCs, the interest would be Subpart F income. As a result, if Branch-2 is disregarded, the CFC at issue here will have lowered its foreign tax on deferred income in a manner wholly inconsistent with the policies and rules of Subpart F.
The past attempts by the IRS’s to rein in the application of the check-the-box rules met with fierce and ultimately decisive opposition. The President’s proposal seeks to revive this debate. His proposal, like that of the IRS some 11 years ago, will provide that, when these sorts of arrangements are undertaken, the branch and the CFCs will be treated as separate corporations for purposes of Subpart F. Accordingly, if the President is successful in implementing his proposals, these types of arrangements would presumably cease to be entered into because they accomplish few, if any non-tax business objectives.
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com
1Section 954(c)(3) of the U.S. tax codes provides that foreign personal holding company income does not include interest received from a related person which (1) is a corporation created or organized under the laws of the same foreign country under the laws of which the CFC is created or organized, and (2) has a “substantial part” of its assets used in its trade or business located in such same foreign country.