Chapter 13
Direct Investment Abroad
Alternative foreign investment situations:
Cf., direct vs. portfolio investment
Alternative direct investment structures:
1) Foreign branch of a U.S. corporation
(or a foreign branch of a U.S. subsidiary)
2) Foreign destination country subsidiary
3) Third country (foreign) subsidiary (& branch
of 3rd country sub in the destination country?)
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Foreign Branch Options
p. 1073
Use (i) U.S. parent corporation or (ii) a special
purpose U.S. (or foreign) subsidiary.
Branch of a U.S. corporation will enable U.S. tax
deductions, e.g., (i) minerals and oil and gas
exploration, and (ii) consolidated return treatment
(loss utilization, but subject to later “recapture”).
No limitation of commercial liability for foreign
branch assets – but, use a special purpose U.S.
subsidiary to hold only this investment.
Use of “start-up losses” for U.S. income tax.
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Foreign Branch Options, cont.
p. 1075
What risk of exposure to the foreign country tax
system?
Possible to avoid P.E. status in destination country if
(1) Applicable bilateral income tax treaty, and,
(2) Limited contacts with the destination country
(e.g., trading activities only).
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Use of a Foreign Business
Organization
p.1076
If a foreign country corporation is used:
1) Subject to tax in that country.
2) Less complication in forming a foreign country
corporation than a branch?
What other local country benefits and
restrictions? E.G. compliance with local
corporate law, such as who are shareholders and
directors.
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Use of a Foreign Business
Organization, cont. p.1076
If a foreign corporation is used, deferral of U.S.
income tax is available, assuming inapplicability of
Subpart F (e.g., deferral if active business
operations occur & tax holidays are available in
the foreign country).
Organization of a foreign corporation may
accommodate foreign joint investors.
What form of foreign business entity should be
used to enable corporate status there? LLC?
Use a “hybrid entity” or a corp. in the foreign
country? Use a one owner “disregarded entity”?
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Problem
Basic Assumptions
p.1078
Western (US) is engaged in U.S. mining.
Planning a mining venture in Country Z.
Initial capital of $300 million in equity.
Terms of the “deal” in the foreign country:
1) royalty to be paid for the mineral product;
2) foreign income tax of 30% on net profits;
3) no withholding tax on div. or royalties;
4) deduction for royalty for process patent.
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Problem Tax/Financial
Analysis
p.1078
Use a branch of the U.S. corporation or a foreign
corporation?
Maintain eligibility for the percentage depletion
deduction for U.S. income tax purposes?
Probably.
Prompt profitability for the project, i.e., no need to
utilize losses.
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Problem 2
p.1079
Setting the Royalty Amount
Establish the royalty amount for the process
payment at the low end ($5 million) or the high end
($10 million)?
Reduction in the royalty reduces the U.S. income
tax to Process by 35% of the unpaid royalty
amount and the Country Z tax only increases by
30% (5% differential).
I.e., “arbitraging the tax rates”?
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Problem 3
p.1079
High foreign country income tax rate.
Other foreign branches with 25% average foreign
tax rate.
High royalty amount for the process patent.
Foreign country project organized as a branch.
Foreign tax credit effects?
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Problem 4
p.1079
Assume other foreign mining ventures and
anticipated excess foreign tax credits for foreign
source residual basket of $5 million.
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Tax Characterization of the
Foreign Business Entity
P.1079
Necessary to have limitation of liability through use
of an entity?
Use a corporation or a (non-corporate) LLC?
Necessary to have two or more owners for an LLC?
Use two special purpose subs in the U.S. to hold
50% (or 90 & 10%?) interests.
Deferral is not important if the foreign tax rate is as
high as or is higher than the U.S. income tax rate.
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Entity Choices Outside the
U.S.
p.1080
Foreign corporation in the host country (and
similar foreign counterparts).
Third country corporation.
Limited liability company (LLC).
Limited partnership (LP).
General partnership (GP).
Contractual joint venture (JV).
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Entity Choices Outside U.S.
- Business Law Aspects
1) Limitation of liability.
2) Control arrangements.
3) Profit sharing split.
4) Foreign country tax burden.
5) Foreign tax credit: (i) availability and (ii) excess
FTC position for U.S. owner.
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Former §7701 Entity/Corp.
Characterization Regs.
1) Associates (both corp. or partnership).
2) Objective to carry on business and divide the
profits (both corp or ptnship, not trust).
3) Continuity of life - death, insanity or bankruptcy
not causing dissolution.
4) Centralized management - non-owner may have
continuing authority to make management decisions
for corporation.
continued
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Former Code §7701
Regulations,
continued
5) Free transferability of ownership interests owners have power, without the consent of other
owners, to substitute others (not previously equity
owners) for themselves in the organization;
6) Limited Liability - no equity owner is personally
liable for the debts of or claims against the
organization.
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Rev Rul. 88-8
p.1083
Foreign Law Criteria Applied
The factual criteria specified in (former) §7701
regulations must be applied in determining the
status of an entity (including foreign entity) as a
corporation for U.S. tax.
Inconsistent classification possible: Use of a hybrid
entity - a corporation for foreign law purposes but
a partnership for U.S. income tax purposes. Cf., a
reverse hybrid (U.S. corp. status; foreign flowthrough status).
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“Check-the-box” Entity Characterization Regs.
P. 1084.
Elective approach of structuring entities to be a (i)
corporation or (ii) partnership for U.S. tax
purposes. Permits the use of “hybrid entities.”
Certain business entities are automatically
classified as corporations for U.S. tax purposes,
including a list of specific foreign entities. Reg.
§301.7701-2(b)(8). Relevant for the classification of
both U.S. and foreign entities. P. 1087.
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Foreign Business Entity
Characterization If Eligible
P. 1087. Unless the foreign entity elects otherwise:
1) treated as association (and a corporation) if all
members have limited liability;
2) treated as a partnership if it has two or more
members and at least one member does not have
limited liability; or
3) disregarded as an entity separate from its owner
if only a single owner that does not have limited
liability.
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Change in Status of the
Foreign Business Entity
Federal income tax effects:
p.1088
1) Eligible entity (partnership or disregarded
entity) elects corporate status – a §351
incorporation transaction & a partnership
distribution.
2) Eligible entity treated as a corporation elects
partnership status – treated as a corporate
liquidation to the shareholders and a
contribution of these assets to a partnership.
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Hybrid Entity Issues p.1089
(Corp. in Foreign Country)
U.S. Corporate Parent
l
Foreign Corp Sub FCountry-1
(As a Holding Co. – Corp. for US Tax)
l
l
Royalty/
Operating Co. 3 (LLC?)
Finance Co. 2
pays royalty &
(LLC?)
interest to Finance Co. 2
(Foreign Country 2)
(Foreign Country 3)
(Co. 2 & 3 are conduits for U.S. income tax; no Subpart F)
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Hybrid Branch & Possible
Limitations
p.1089
Notice 98-11 - separate status for hybrids (p.1090)?
Hybrid branch as a separate entity? Then,
payments made are FPHC income.
Temporary Regs. - T.D. 8767, withdrawn.
Notice 98-35 - withdrawing these items
Proposed Regs. 1.954-9, pending (next slide)
Issue: Should IRS be able to promulgate a “branch
rule” for FPHC income?
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Hybrid Branch
P.1091
Prop. Regs. §1.954-9 (1999)
1. Hybrid payments to a related entity reducing
foreign country tax and being FPHC would be
recharacterized as Subpart F income.
2. Hybrid status: fiscally transparent in the
US but not fiscally transparent in the country of
the payor entity.
3. “Tax disparity” test satisfied (less than
90% rate of the payor’s tax)?
Regs. still remain in proposed form in 2015.
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International Tax Arbitrage
p.1092
1. Double dip deal - interest deductible in payor
country but not income in payee country (since
intracompany payment). §901 credit available.
2. Subpart F is avoided. No foreign base company
income through use of the branch.
3. “Check & sell.” After tax-free liquidation Co.
sells assets and not stock and, therefore, no
foreign personal holding company income. Tax
disparity test is satisfied (less than 90% rate of
payor’s tax). Dover case (on p. 552).
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Extraordinary Transaction
Rule
p.1096
Proposed “Extraordinary Transaction” Rule –
Prop. Reg. §301.7701-3(h), where a transaction
occurs in close proximity to an election to change an
entity’s tax classification. E.g., within 12 months of
the election.
Note: “check and sell” transactions.
Withdrawal of this rule - Notice 2003-46.
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JCT Staff Proposal
p.1097 Single Member Co.
2005 proposal: Treat as a corporation for U.S. tax
purposes the foreign entity which:
1. Is a separate business entity as organized under
foreign law; and,
2. Is a separate entity having only one member.
And, possible regs. to preclude the division of
ownership to avoid this corp. status rule.
The problem ultimately derives from too broad
“check-the-box” rules.
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Obama Proposal
p.1100
FY 2010 proposal: Treat as a corporation for U.S.
tax purposes the foreign entity which:
1. Is a separate business entity organized under
foreign law; and,
2. Is a separate entity having only one member.
Except where organized in the same country.
But, now Code §954(b)(6) enabling avoidance of
Subpart F treatment (through 12-31-2014).
Obama proposal abandoned for FY2011 & later.
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Obama Proposal
FY2016
FY 2016 proposal:
Restrict use of hybrid entities used to create
“stateless income”, i.e., deduction in one
jurisdiction and no inclusion in any other foreign
jurisdiction.
Greenbook, p. 35.
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Dual Resident Corporations
& DCLs
p.1102
U.S. corporation is permitted to file a consolidated
tax return with its affiliated corporations. §1501.
Losses of one group U.S. member can offset the
income of another U.S. group member. §1504.
Another country may treat a corporation as
resident under the “management and control” test.
Dual resident corps cannot “double dip” for losses.
§1503(d). P.1105.
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Code §904 FTC Limitation
& Planning Options p.1110
Structuring of arrangements to enable reduction of
the overall effective foreign tax rate (through
low/no taxed arrangements):
1) Lending money and generating interest expense
deduction in foreign country and lower withholding
rate imposed on the outbound interest payment.
2) Export of goods - pass title to (i) generate foreign
source income and (ii) avoid any income tax in the
foreign jurisdiction. cont.
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Code § FTC Limitation
Planning Problems, cont.
3) Technology licensing arrangement with the
foreign subsidiary and extraction of low/no taxed,
deductible royalty, to which the look-through rules
are applicable for FTC.
4) Managerial and technical services in foreign
country - same planning objective, i.e., deductibility
of payment for local country income tax and low/no
withholding tax at source of payment.
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Capitalization of the
Foreign Corporation p.1112
Use debt or special class(es) of stock?
Is the interest on the debt deductible for foreign
country income tax purposes? Cf., §163(j).
And, FTC “look-through” rule. §904(d)(3).
Debt arrangement enables the tax-free repayment
of principal (not treated as dividend but basis
recovery) and is free of the applicability of the
withholding at source rules (if treaty).
Cf., stock redemption treatment under §302.
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Capitalization of the
Foreign Corporation, cont.
P. 1114. Transfer of intangibles as:
1. Contribution to capital (consider §§351 &
367(d)) (ordinary income), or
2. Intangibles sale, lease or license (consider §482).
Consider (a) applicability of sourcing rules & (b)
tax characterization rules - ordinary income or
capital gain (e.g., sale of patent for a fixed price or
for royalty payments).
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Capitalization of the
Foreign Corporation, cont.
P. 1116. Transfer of tangible property (e.g.,
equipment and real property:
No gain recognized on the transfer, except for
depreciation recapture.
Generate: (1) foreign source income; (2) general
limitation income (for FTC purposes).
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International Joint Venture
Conceptual Framework
P. 1117 What is a “joint venture” - two or more
participants with a common business objective.
Type of entity? Many choices:
- corporation (foreign or domestic), including a
“special purpose” subsidiary
- partnership or LLC
- contractual arrangement (no tax entity)
What requirement for a “local partner”?
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International Joint Venture
Documents
p.1118
"Heads of Agreement” or “Memorandum of
Understanding” (MOU).
Accompanying documents:
1) Organizational documents for the specific entity,
e.g., Articles of Incorporation; Partnership
agreement; by-laws and code of regulations;
organizational meeting minutes.
2) Loan agreements
continued
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Structuring Joint Venture,
cont.
3) Shareholder/owner agreements re control of
entity & buy-sell agreement (use a “shotgun” buysell agreement? P. 1125)
4) Technology licensing agreements.
5) Technical assistance agreements.
6) Management contracts.
7) Employment contracts for key personnel.
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Control Arrangements for
the Joint Venture company
P. 1119.
1) U.S. minority ownership situations.
Better to use a corporation because of greater
participatory rights under local business entity laws
(but consider U.S. tax planning re no flow-through).
2) U.S. minority but effective control.
3) U.S. participant with majority control.
4) 50-50 joint venture.
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Countering Foreign
Control Situations
Veto rights over certain actions. P.1121.
Independent financial accounting required.
Required dividend distributions.
Limits on compensation payments allowable to
controlling parties.
Indirect influence through supply contracts,
technology contracts, trademarks, secured debt
financing, etc.
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Achieving Effective Control
p.1123
Control over entity management through
designation of the managing director.
Alternatively, control achieved through the use of a
management contract.
Query whether local business law permits such
delegation of authority.
Cf., difficulties with deadlock (50-50) situations use a “shotgun” buy-sell agreement. P.1125.
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U.S. Tax - Organizing the
Foreign Joint Venture
Classification of the jointly owned foreign
corporation as a CFC?
P.1127
Beneficial to be treated as a CFC?
Consider the Code §904 foreign tax credit baskets
& look-through rules - §904(d)(3).
Note, however, the FTC changes for 10-50 corps.
(look-through rules for post 2002 income).
What negatives of CFC status? Next slide
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Negatives of CFC Status
p.1128-9
1) Foreign base company income (Subpart F
income) possibilities.
2) Constructive dividend treatment for investment
in U.S. property. §956.
3) §1248 – ten percent or greater shareholder of
CFC has dividend treatment (rather than capital
gain) when selling CFC shares (including
liquidation). But. preferring §1248 treatment
(since indirect FTC availability)?
4) §1249 – re patent sales to CFC. P. 1129.
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Control of the Foreign
Corporation
p. 1130
How determine if “control” status exists?
1) Several classes of stock.
2) Holding power to designate the managing
director of the corporation.
3) What deadlock resolution arrangements exist?
4) Purpose of avoid CFC status?
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Estate of Weiskopf
p. 1131
§1248
Was the foreign corporation a CFC for §1248
purposes (applicable when the stock is sold)?
Creation of a U.K. company (Ininco) qualifying as
an "Overseas Trade Corporation" (OTC).
Court: Rejecting argument Romney (a U.K. Co.)
held 50 percent of voting rights of Ininco.
U.S. shareholders controlled the product.
Therefore, Ininco held to be a CFC and not a
“deadlock” company. Cf., Koehring case.
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Rev. Rul. 70-426
p. 1139
Y foreign corporation has two classes of stock: (i)
100 shares of no par value class A stock & (ii) 100
shares of $1 par class B stock
Class B stock has a preference on dissolution and a
preference for annual dividends (but limited
amounts). Class B was foreign owned.
Corporate charter for one year with 75 percent
shareholder approval required to renew the
charter.
continued
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Rev. Rul. 70-426, cont.
X, a domestic corporation, owns all the Class A
stock.
X, owning 50 percent of the total combined voting
power of Y, has the power to force Y foreign
corporation into liquidation.
Consequently, X has necessary power and Y
corporation is a CFC.
Relevance? E.g., if a corp. liquidation & §1248.
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Problems
CFC Status?
p.1141
Assuring CFC status:
a) Control over the manager’s continuation in
office.
b) Management contract.
c) Right to force liquidation or terminate
important licensing agreement if deadlock
situation.
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Pass-through Treatment
With a Partnership p.1144
If a corporation must be used, use a U.S.
partnership to hold the stock of the foreign
corporation to get CFC status.
Does the foreign corporation therefore constitute a
CFC? Or, will the partnership be disregarded and
the partners be treated as directly holding a 50
percent interest--applying an aggregate, rather
than an entity, theory of partnership?
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Jointly Owned Foreign
Partnership
p.1145
Losses and deductions will immediately flow
through to the partners.
Income will also flow-through, but also available
will be direct foreign tax credits (which would not
be available to shareholders, unless 10% or greater
interest, under the deemed paid credit rules).
Same treatment if a LLC is treated as a
partnership.
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Selection of the Foreign
Joint Venture Entity
Check the box regulations enable choice of entity,
but a problem may still exist with the foreign joint
venturer who does not want to elect partnership
status where all the owners have limited liability
status.
Solve with:
1) organizational documents?
2) subsidiary to hold partnership interest?
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Interposition of a 3rd
Country Holding Company
Wholly owned foreign corporation organized under
the laws of a third country interposed between the
U.S. parent company and the foreign operating
company.
Third country treaty network available?
Dividends upstream to the foreign holding company
will be recharacterized under the look through
rules for FTC purposes. cont.
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Interposition of a Holding
Company
continued
If the foreign operating company is not a CFC, then
the dividends (and rents, royalties and interest) will
be foreign base company income to the
intermediate holding company (but look through
when these rules became available to 10-50
corporations).
Use foreign holding company to reduce taxation on
the earnings when distributed from the foreign
country operating sub.
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