IRS takes controversial approach to characterization of separately stated item of subpart F income.

• Author: Rubinger, Jeffrey L.
• Position: Tax Law

After several months of internal debate and discussions, the IRS recently refused to issue a private letter ruling pertaining to the ability of a constructive U.S. shareholder of a controlled foreign corporation (CFC) to make a retroactive [section] 962 election. (1) The issue was not whether the U.S. shareholder satisfied the requirements for seeking retroactive relief under the [section] 9100 regulations, as the IRS agreed that those requirements had been met. (2) Rather, the issue was whether a U.S. shareholder that constructively owns a CFC through a 100 percent owned S corporation (which, for subpart F purposes, is characterized as a single-member partnership under [section] 1373(a)) has an amount that is "included in his gross income under [s]ection 951(a)" when the partnership has such an inclusion.

The IRS is of the view that, despite the unambiguous language of [section] 702(b), the clear legislative intent behind [section] 962, and analogous guidance issued by the IRS, a constructive U.S. shareholder of a CFC does not have the ability to make a [section] 962 election on the grounds that a separately stated item of [section] 951(a) income under [section] 702(a) is not equivalent to a direct inclusion of [section] 951(a) income. Stated differently, the IRS ignored the "conduit" nature of [section] 702(b) and argued that the U.S. shareholder did not have a [section] 951(a) inclusion, but instead had a [section] 702(b) inclusion of [section] 951(a) income. According to the IRS, these are two entirely different things. This article will discuss the arguments raised by the IRS and the taxpayer in connection with the ruling and consider some of the potential ramifications of the IRS position with respect to other U.S. international tax provisions.

Controlled Foreign Corporations

In general, a CFC is a foreign corporation that is more than 50 percent owned (by vote or value) by U.S. shareholders. (3) A "U.S. shareholder" is defined as a U.S. person (within the meaning of [section] 957(c)) that owns directly (as defined in [section] 958(a)(1)), indirectly (as defined under [section] 958(a)(2)), or constructively (as defined under [section] 958(b)) 10 percent or more of the CFC's voting stock. (4)

For purposes of determining whether a foreign corporation is a CFC, the ownership by U.S. shareholders can be direct, indirect, or constructive. Once it is determined that a foreign corporation is a CFC, however, it is only those U.S. shareholders of the CFC that own (within the meaning of [section] 958(a)) (i.e., directly or indirectly) stock in such corporation on the last day in such year on which such corporation is a CFC that must include in their gross income 1) their pro rata share of the CFC's subpart F income, and 2) the amount determined under [section] 956 with respect to such shareholders for such year ([section] 951(a) inclusions). (5) In other words, constructive U.S. shareholders are not directly taxed on [section] 951(a) inclusions.

The [section] 962 Election and Deemed Paid Credit

Section 962 allows an individual (or trust or estate) U.S. shareholder of a CFC to elect to be subject to corporate income tax rates on amounts which are included in his or her gross income under [section] 951(a). The purpose behind [section] 962 is

to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. This provision gives such individuals assurance that their tax burdens, with respect to these undistributed foreign earnings, will be no heavier than they would have been had they invested in an American corporation doing business abroad. (6)

The [section] 962 election accomplishes this result by allowing the U.S. shareholder to obtain an indirect foreign tax credit under [section] 902 for a pro rata portion of any foreign taxes paid by the CFC.

Specifically, [section] 962 provides that under regulations prescribed by the secretary, in the case of a U.S. shareholder who is an individual and who elects to have the provisions of this section apply for the taxable year: 1) the tax imposed under this chapter on amounts which are included in his gross income under [section] 951(a) shall (in lieu of the tax determined under [section][section] 1 and 55) be an amount equal to the tax which would be imposed under [section][section] 11 and 55 if such amounts were received by a domestic corporation, and 2) for purposes of applying the provisions of [section] 960 (relating to foreign tax credit) such amounts shall be treated as if they were received by a domestic corporation.

The U.S. federal income tax consequences of a U.S. individual making a [section] 962 election are as follows. First, the individual is taxed on amounts included in his gross income under [section] 951(a) at corporate tax rates. Second, the individual is entitled to a deemed-paid foreign tax credit under [section] 960 as if the individual were a domestic corporation. Third, when the CFC makes an actual distribution of earnings that has already been included in gross income by the shareholder under [section] 951(a), the earnings are included in gross income again to the extent they exceed the amount of U.S. income tax paid at the time of the [section] 962 election. (7)

Sections 1373(a) and 702(b)

Section 1373(a) provides that "[f]or purposes of ... subpart F [section][section] 951 through 965], ... an S corporation shall be treated as a partnership, and the shareholders of such corporation shall be treated as partners of such partnership." Under [section] 702(a)(7) and Treasury Regulation [section] 1.702-1(a)(8)(ii), each partner is required to take into account...