Individuals' use of offshore holding companies.

• Author: Schmidt, Paul M.
• Position: Part 2

EXECUTIVE SUMMARY

* A foreign corporation will be considered a PFIC if it meets either a gross-income test or an asset test.

* A foreign corporation may simultaneously meet the definitions of both a PFIC and a CFC with respect to a U.S. shareholder.

* Under U.S. tax rules, a foreign entity may be characterized as a trust, a corporation, a partnership, or an entity disregarded as separate from its owner.

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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 II explores using an offshore company to make significant investments in foreign businesses.

Part I of this article, in the August 2007 issue, introduced the two main anti-deferral regimes applicable to foreign corporations controlled by U.S. shareholders and explored the general federal income tax consequences related to portfolio-type investments by such corporations. As illustrated therein, there are often compelling reasons to deter a client from forming an offshore company for the purpose of holding passive investments.

Part II, below, explores the tax consequences of using an offshore company to make more significant investments in foreign businesses, including situations in which the use of an offshore holding company may be consistent with bona fide U.S. federal income tax planning objectives. As in Part I, the discussion focuses on practical tax advice that U.S. tax professionals with limited international tax exposure may provide to moderate- and high-net-worth clients seeking to defer U.S. federal income tax using offshore holding companies.

Basic Anti-Deferral Regimes

The two primary U.S. anti-deferral regimes, the controlled foreign corporation (CFC) rules and the passive foreign investment company (PFIC) rules, were introduced in Part I. This part reviews these rules and introduces some additional concepts concerning both regimes. To assist in the analysis, the U.S. entity-classification rules as they apply to foreign legal entities are reviewed.

CFC Rules

Sec. 957(a) defines a CFC as a foreign corporation with respect to which U.S. shareholders collectively own stock representing greater than 50% of the combined voting power or value. U.S. shareholders of a CFC generally are required to currently include the CFC's subpart F earnings in income, regardless of whether an actual dividend has been distributed, under Sec. 951(a)(1). A CFC's subpart F income includes the foreign personal holding company income (FPHCI) earned by a CFC, as well as special types of sales and services income. (14) Generally, FPHCI includes dividends, interest, rents, and royalties earned by a CFC. Through 2008, however, those forms of income received by a CFC from a related person will not be treated as subpart F income. (15) Under Regs. Sec. 1.952-1(g)(1), income received by a CFC from a lower-tier partnership is generally tested on a lookthrough basis. Further, under Sec. 954(c)(4), gain on the sale of a partnership interest by a CFC is characterized on a lookthrough basis if the CFC owns a 25%-or-greater interest in the partnership. If this ownership requirement is not met, under Sec. 954(c) (1) (B) (ii), gain on the sale of the partnership interest generally results in subpart F income.

Rules Applicable to PFICs

A foreign corporation will be considered a PFIC if it meets either a "gross income" test or an "asset" test. Under the gross-income test, a foreign corporation will be treated as a PFIC if 75% or more of its income for the year is FPHCI (within the meaning of Sec. 954(c)). Under the asset test, a foreign corporation will be considered a PFIC if greater than 50% of its assets produce, or are held for the production of, FPHCI.

Taxation of PFIC income: In contrast to CFC rules, a shareholder of a PFIC is not subject to a current income inclusion unless it elects to treat the PFIC as a qualified electing fund (QEF). (16) A shareholder of a PFIC that does not make the QEF election is taxed only on receipt of a distribution from the corporation in the form of a dividend. However, under Sec. 1 (h) (11) (C) (iii) , the dividend distribution will not qualify for the reduced 15% rate applicable to certain qualified dividends. Further, a portion of any dividend paid by a PFIC may be subject to additional tax under the "excess distribution" rules (i.e., essentially an interest charge imposed on the deferred tax liability). The excess distribution rules serve to impose a "toll charge" that must be paid for any tax deferral on the income that supports the excess distribution.

Under Sec. 1291(b), an "excess distribution" is the portion of a PFIC dividend in excess of the foreign corporation's historic distribution levels (i.e., any amount in excess of 125% of the average distributions of the PFIC during the preceding three years). The excess distribution amount is then allocated over the shareholder's entire holding period for the PFIC stock on a daily basis. To the extent a portion of the excess distribution is allocated to a prior year, tax is determined on such amount by multiplying it by the highest tax rate in such year and then adding an...