Moving the "management and control" of a foreign corporation to achieve favorable U.S. tax results.

• Author: Rubinger, Jeffrey L.
• Position: Part 2

Look-through Rule

The controlled foreign corporation (CFC) could be owned by a company formed in a jurisdiction that has a comprehensive income tax treaty with the United States, provided that jurisdiction has a favorable "participation exemption" which exempts foreign-source dividends from corporate income tax. (1) Examples of such jurisdictions include Australia, Austria, Cyprus, Hungary, the Netherlands, and Switzerland. (2) In that situation, the dividend paid by the CFC to the foreign holding company (which also will be a CFC) should not generate subpart F income under the [section] 954(c)(6) look-through rule. The dividend paid by the foreign holding company to the United States may then be eligible for qualified dividend income treatment under [section] 1(h)(11). (3)

* Same-country Exception--In the alternative, the CFC could be owned by another entity formed in the same jurisdiction where the CFC is created or organized to take advantage of the same-country exception. Depending on whether that jurisdiction has a comprehensive income tax treaty with the United States, it may be necessary to move the management and control of that entity to a more favorable jurisdiction that has such a treaty. For example, in the case where the CFC is formed in the UAE, it may be possible to form a foreign holding company in the UAE and move the management and control of such holding company to a jurisdiction that has a comprehensive income tax treaty with the United States and has a favorable participation exemption that exempts foreign-source dividends from tax, such as Cyprus. (4)

Under this structure, the dividend paid by the lower-tier UAE entity to the upper-tier UAE entity should not generate subpart F income under the same-country exception. A dividend can then be paid from the foreign holding company (which would be a tax resident of a treaty country) to the United States at a 15 percent rate. It would be more beneficial from a U.S. tax perspective to take advantage of the same-country exception rather than the [section] 954(c)(6) look-through rule to avoid subpart F income on the receipt of the dividend, because the qualified dividend income provisions are currently scheduled to expire at the end of 2010, but the [section] 954(c)(6) look-through rule is scheduled to expire at the end of 2008. Thus, the same-country exception seems to be the better (albeit more complicated) alternative so that no further restructuring needs to be done before the qualified dividend income rules expire. (5)

It is important to note that in order for this structure to properly allow a U.S. citizen (UST) to avoid subpart F income and have the ability to repatriate the service fees at qualified dividend income rates, (6) the "personal service contract" provisions in subpart F, which were formerly contained in the foreign personal holding company rules ([subsection] 551 through 558), (7) need to be carefully addressed as well. Since the repeal of the foreign personal holding company provisions, FPHCI of the subpart F income rules now include as a category of income amounts received by a CFC under a written or oral contract to provide personal services, provided two conditions are met:

(1) some person other than the CFC has the right to designate the performer of the services, or the contract designates the performer; and

(2) the designated performer or any performer who could be designated under the contract directly, indirectly, or constructively owns 25 percent or more in value of the outstanding stock of the corporation at any time during the tax year in which the foreign corporation receives the income. (8)

Therefore, in order for the service fees not to be considered "personal service contract" income, the service contract signed by the CFC needs to be carefully drafted. Generally, this can be accomplished by having the contract give the CFC itself the actual right to designate the service provider, regardless if all parties know who the service provider will be (i.e., UST). Of course, this knowledge should not be specified in the actual service agreement and the CFC providing the services should retain the legal authority to select the person(s) who will provide the services. (9) For this purpose, in determining whether a "personal service contract" exists, the IRS asks whether third parties have a contractual right (written or oral) to require the performance of services by the controlling shareholder. (10) In this regard, such a contractual right must be explicit, and generally cannot be inferred from the fact that the person who is to perform the services is the corporation's sole employee. (11)

Avoiding the [section] 7874 Inversion Rules

Prior to the enactment of [section] 7874, a number of U.S.-based multinationals engaged in so-called "inversion" transactions to reinvent themselves as foreign-based multinationals. Although inversion transactions were accomplished in several ways, in each case the result was that the former shareholders of the U.S. corporation received shares of a new foreign parent corporation in exchange for their shares of the former U.S. parent in a transaction that was taxable under [section] 367(a). (12)

The basic purpose of the...