Individuals' use of offshore holding companies.

• Author: Schmidt, Paul M.
• Position: Part 1

High-net-worth clients often question their tax professionals about using offshore holding companies to avoid taxes. This two-part article discusses the tax consequences for the average taxpayer and considers when foreign corporations should (and should not) be used. Part I examines the controlled foreign corporation rules as they relate to portfolio-type investments through the use of foreign holding companies.

Moderate- to high-net-worth individuals frequently solicit advice on the potential for achieving tax savings via the use of offshore holding companies, inevitably located in a low-tax jurisdiction. A client's motivations for wanting to form an offshore holding company are often as vague and unidentifiable as his or her understanding of the tax objectives intended to be achieved. Often some acquaintance (e.g., doctor, lawyer, dentist, in-law, college roommate, etc.) has told the client that he or she has an offshore corporation that does not pay tax on its income (because it is not a U.S. taxpayer).

To best serve (and keep) such clients, a tax adviser must be able to provide a similar solution, or convince the client that such a strategy does not provide the perceived tax benefits. This two-part article will provide tax practitioners that do not routinely deal with international tax issues a guide as to why the use of a foreign corporation to shelter passive income from U.S. tax usually has negative tax consequences for the average taxpayer. There are, of course, occasions in which use of a foreign corporation to isolate earnings from U.S. tax is a fundamental element of sound Federal income tax planning (particularly when acquiring an interest in an active foreign business). Using various examples, some of the circumstances in which such an investment structure should be considered will be examined and illustrated.

Part I provides an overview of the controlled foreign corporation (CFC) anti-deferral regime as it relates to "portfolio-type investments" through a foreign holding company (FHC) structure (i.e., shifting capital to an offshore corporation to facilitate conventional investments in publicly traded stocks and bonds), and the statutory deterrents to using such a structure. Part II, in the September 2007 issue, will illustrate the tax consequences of an FHC's investments in an array of foreign business opportunities, including foreign partnerships, investment funds and closely held foreign corporations, and provide examples in which use of an FHC may be consistent with sound tax planning objectives.

Basic Anti-Deferral Regimes

For a taxpayer to benefit from deferral, the foreign entity that holds the income-producing property or activity must be a foreign corporation. If a U.S. taxpayer invests through a foreign entity that is treated as a partnership, branch or disregarded entity for Federal income tax purposes, it will remain subject to tax on its allocable share of the entity's income, regardless of whether the partnership is formed under domestic or foreign law. Accordingly, the general rules applicable to the taxation of foreign corporations owned by U.S. persons must first be considered.

There are two main anti-deferral regimes under which the U.S. imposes tax on the income of a foreign corporation with U.S. shareholders. These regimes operate by applying special tax rules to shareholders of foreign entities that qualify as either CFCs or passive foreign investment companies (PFICs). Both sets of rules are aimed predominantly at taxing a U.S. shareholder on the foreign corporation's passive and "mobile" income (i.e., income that may easily be shifted to low-tax jurisdictions). If the rules apply, the U.S. shareholder may either: (1) be taxed currently on the foreign corporation's income, despite the fact that no income was repatriated to the shareholder through a distribution; or (2) face a somewhat punitive interest charge (in addition to the shareholder's ordinary income tax liability) on an ultimate distribution to the U.S. shareholder or disposition of the entity's stock.

Rules Applicable to CFCs

Determining CFC Status

Sec. 957(a) defines a CFC as a foreign corporation with respect to which "U.S. shareholders" collectively own...