Forms of overseas operations.

• Author: Lau, Paul C.
• Position: Part 2

EXECUTIVE SUMMARY

* A partnership may allow immediate flowthrough of FTCs and losses, but is subject to complex U.S. rules when allocating income, gain, losses and taxes.

* Foreign corporations are generally the preferred choice for domestic C corporations when the primary goal is deferral of U.S. income tax; a C corporation can claim an indirect FTC when foreign subsidiaries distribute earnings.

* U.S. shareholders of foreign corporations can be subject to tax under the CFC and PFIC anti-deferral provisions; the FPHC provisions have been repealed.

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This two-part article explores the major characteristics, advantages and disadvantages of the different forms of business organizations available for conducting business overseas. Part II discusses foreign partnership and corporate organizations.

U.S. companies doing business in a foreign country generally can choose to operate a branch, partnership or corporation. This two-part article examines the tax consequences of these alternatives. Part I, in the March 2005 issue, focused on branch operations. Part II, below, examines foreign partnership and corporate entities.

Partnerships

Under the check-the-box regulations, a foreign business entity that is not a corporation per se can elect to be treated (or be treated by default) as a partnership if it has two or more members. The partnership's income and losses flow through to its U.S. partners. However, the U.S. partnership tax rules add complexities to a foreign partnership's operations. As a result, the partnership agreement should address all the important tax and nontax issues. If it does not, local law will be deemed to be part of the agreement, under Regs. Sec. 1.761-1(c). To avoid future confusion and conflict, any differences between foreign laws and U.S. rules (on allocations and distributions, for example) should be addressed and resolved at partnership formation.

Substantial Economic Effect

A key tax feature of U.S. partnerships is their ability to allocate items of income, gain, loss and deduction among the partners in ratios that differ from those in the partners' capital accounts. Disproportionate or special allocations, however, must satisfy the "substantial economic effect" regulations under Sec. 704(b); under Regs. Sec. 1.704-1(b)(2)(ii), the following provisions should be in the partnership agreement:

1. The partners' capital accounts will be maintained in accordance with Regs. Sec. 1.704-1(b)(2) (iv);

2. Liquidating distributions will be made in accordance with the partners' positive capital account balances; and

3. A deficit capital account balance will be unconditionally restored by a partner following the liquidation of its partnership interest, or be subject to the qualified income offset rules of Kegs. Sec. 1.704-1(b)(2)(ii)(d).

   Sec. 704(c) Gain/Loss

   Another vital tax feature of U.S. partnerships is the Sec. 704(c) built-in gain (BIG) or loss (BIL) allocation rules. Sec. 704(c) applies to a contribution of property when its fair market value (FMV) differs from its tax basis (i.e., it has BIG or BIL). Sec. 704(c) allocates the BIG or BIL to the contributing partner. The partnership agreement should specify the allocation method(s), giving due consideration to the anti-abuse rules in Regs. Sec. 1.704-3(a)(10).

   The American Jobs Creation Act of 2004 (AJCA), Section 833(a), created new Sec. 704(c)(1)(C), which requires the BIL on contributed property to be allocated only to the contributing partner. The property's basis would be treated as equal to its FMV at contribution for the purpose of allocating items to the noncontributing partners.

   New BIL Basis Adjustment Rules

   AJCA Section 833(b) and (c) mandate a basis step-down in partnership assets if a "substantial" BIL (or a substantial basis reduction) exists when a partnership interest is transferred (or liquidated). For a transfer of a partnership interest, a substantial BIL exists if the partnership's aggregate adjusted basis in all of its property exceeds the aggregate FMV of its property by more than $250,000, under new Sec. 743(d).

   Under new Sec. 734(d), there is a substantial basis reduction when a partnership interest is liquidated, if the sum of the (1) redeemed partner's recognized loss and (2) portion of the distributed property's substituted basis in the redeemed partner's hands that exceeds the partnership's adjusted basis, is more than $250,000.

   DCL

   Another complexity is how to compute a partnership interest's dual consolidated loss (DCL), as the IRS has yet to issue any guidance. Without special allocations, a partner's allocable share of partnership loss should be that partner's DCL. However, it is unclear how the partner's DCL would be determined if a loss item were allocated to a U.S. partner for U.S. tax purposes, and to a foreign partner for foreign tax purposes.

   Interest Expense Apportionment

   Special rules apply to the apportionment of partnership interest expenses. A corporate general partner or any limited partner cannot allocate its share of partnership interest expenses between foreign- and U.S.-source income for foreign tax credit (FTC) purposes if its partnership interest is less than 10%. Instead, under Temp. Regs. Sec. 1.861-9T(e)(4), its distributive share of interest expense has to directly offset its share of partnership gross income. This rule can reduce the FTC limit, because the partnership's foreign-source income is fully decreased by the interest expense.

   Another problem occurs when a U.S. partner makes a loan to a foreign partnership. Generally, interest expense is apportioned between foreign- and U.S.-source income based on the taxpayer's source of assets. A loan to a foreign partnership potentially requires the U.S. partner to double-count the foreign-source assets when apportioning interest expense, because the loan would be reflected in the foreign-source asset basis twice. The partner's basis in the loan is reflected as a receivable from the foreign partnership. In addition, the partner has an allocated share of its loan as the basis in its partnership interest, under Secs. 752(a) and 722. This double-counting of the loan as foreign-source assets can result in (1) disproportionately more interest expense being apportioned to foreign-source income and (2) a reduction in the FTC limit. (20)

   Transfer Pricing

   Transactions between a partnership and a U.S. partner are subject to complex transfer-pricing rules. A U.S. taxpayer must maintain contemporaneous documentation to establish the reasonableness and reliability of its transfer-pricing methods. Failure to comply can result in a transfer-pricing penalty on a substantial tax under-payment. Under Sec. 6662(a) and (h), the penalty is 20% or 40% of the underpayment, depending on the amount of the transfer-pricing adjustment.

   Partnership Income Tax Allocations

   Finally, the allocation of foreign income taxes among partners has been an area of considerable uncertainty. Foreign income taxes pass through from the partnership to the partners. Under Sec. 702(a)(6), each...