A new regulation from the Internal Revenue Service targets so-called blocker partnerships, making certain income held by foreign investors taxable in the United States. In the past, if there was no “effectively connected income” between a blocker corporation and its foreign investors, the corporation would file and pay U.S. taxes at the regular corporate rate, but the investors received only dividends or capital gains from the partnership, and never had to file with the IRS.
The new regulation, issued in May (IRS Notice 2010-41), reclassifies blocker corporations as controlled foreign partnerships (CFCs), thereby triggering income inclusion for these entities. (A CFC is a company that conducts business in a country other than the residency of the controlling shareholders; and control is defined by the share percentage owned by U.S. citizens.)
The rationale behind the reclassification is explained in the new notice, which is examined in this column.
In the IRS notice, a U.S. corporate taxpayer (USCorp) owns all the stock of two CFCs — for the purpose of this column called Alpha and Beta. Alpha and Beta are equal partners in a domestic partnership, which owns all of the stock of Omega. In addition, Omega earns “Subpart F” income.
In broad terms, Subpart F refers to a category of CFC income not included in the gross income of a U.S. person. USCorp takes the position that it does not have to include in its tax calculations the income of Omega because the partnership between Alpha and Beta is the first U.S. person in the chain of ownership of Omega. However, the new IRS regulation ensures that the corporate taxpayer now has an income inclusion with respect to Omega.
Controlled Foreign Corporations
The Internal Revenue Code discusses Subpart F income with respect to CFCs in Section 951(a). Specifically, the subsection deals with companies that are CFCs for an uninterrupted period of 30 days or more during any taxable year. It states that a “U.S. shareholder” of a CFC that owns1 stock in the company on the last day of a taxable year in which it is a CFC must include in gross income its pro-rata share of the corporation’s Subpart F income — as well as amounts determined under Section 956, which relates to certain pledges and guarantees.
Another subsection — Section 951(b) — defines a U.S. shareholder with respect to CFCs, noting that a “U.S. person”2 that owns (within the meaning of Section 958(a)) or is considered as owning under Section 958(b), 10% or more of the total combined voting power of all classes of stock entitled to vote.
If the general definition of a U.S. person provided by the tax code applies to the facts in the IRS notice, the domestic partnership between Alpha and Beta is the U.S. shareholder required to include in gross income the amounts determined under Section 951(a) with respect to Omega.