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.
However, the notice states that the gross income inclusion may have “little or no tax consequences, depending on the treatment of each partner’s distributive share of such income.” In fact, the Treasury Department and the IRS believe that the taxpayer’s position is contrary to the purpose and intent of the tax code’s Section 951. Therefore, the Treasury Department and the IRS have determined that the general definition of a domestic partnership under Section 7701(a)(4)3, in the case of certain partnerships owned by foreign corporations, is manifestly incompatible with the intent of Section 951.
“Re-Domiciling” a Domestic Partnership
Accordingly, the agencies promulgated regulations that treat a domestic partnership as foreign solely for purposes of identifying the U.S. shareholder of a CFC required to include in gross income the amounts determined under Section 951(a). These regulations will operate in cases where:
• The partnership is a U.S. shareholder of a foreign corporation that is a CFC;
• If the partnership were treated as foreign, that foreign corporation would continue to be a CFC;
• At least one U.S. shareholder of the CFC would be treated as indirectly owning stock of the CFC owned by the partnership that is indirectly owned by a foreign corporation and would be required to include an amount in gross income under Section 951(a) with respect to the CFC.
That means that a domestic partnership to which the regulations apply will continue to be classified as domestic for all other purposes. In the instant case, the domestic partnership between Alpha and Beta would be treated as foreign because:
• The partnership would be a U.S. shareholder of a foreign corporation that is a CFC (Omega) if the regulations did not apply;
• If the partnership were treated as foreign, (1) Omega would continue to be a CFC and (2) the corporate taxpayer, USCorp (a U.S. shareholder of Omega), would be treated as indirectly owning the stock of Omega owned by the partnership that is indirectly owned by Alpha and Beta, and therefore would be required to include in gross income the amounts determined under
Section 951(a) with respect to Omega.4
These new regulations apply to taxable years of a domestic partnership ending on or after May 14, 2010.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 Ownership within the meaning of Section 958(a).
2 U.S. person as defined in Section 957(c).
3 Section 957(c) defines a U.S. person by reference to Section 7701(a)(30). Section 7701(a)(30)(B) defines a U.S. person to include a domestic partnership. Section 7701(a)(4) provides that the term domestic when applied to a corporation or partnership, means created or organized in the United States. However, Section 7701(a) provides that any general definition included therein does not apply where such definition is manifestly incompatible with the intent of the relevant Code provision.
4 See Section 958(a)(2) of the Internal Revenue Code; stock owned by a foreign corporation or foreign partnership shall be considered as being owned proportionately by its shareholders and partners.