Sec. 962 to the rescue.

• Author: Polantz, Raymond M.
• Position: Foreign tax credit claim relief

As the world continues to get smaller, forward-looking companies are finding that doing business overseas is not just a luxury but a necessity to keep pace with increased competition. Many small and midsize businesses now find themselves owning foreign subsidiary corporations, meaning they are managing the same international tax issues once reserved for large publicly held companies.

Small and midsize businesses are often organized as S corporations, partnerships (including limited liability companies treated as partnerships for tax purposes), and even as sole proprietorships. While these forms of business offer certain domestic tax benefits (namely, the avoidance of double taxation inherent in C corporations), international tax provisions, including the anti-deferral regime and mechanics of the foreign tax credit, can present significant and unique challenges to maintaining a tax-efficient structure.

Anti-Deferral Regime

Under Sec. 951(a), U.S. taxpayers must include in income their share of subpart F income and their share of Sec. 956(a) income. Subpart F of the Code was originally enacted to address concerns that taxpayers could defer certain types of U.S. income tax by placing the income in a foreign corporation organized in a low-tax jurisdiction, consequently deferring the U.S. tax until it was repatriated. Subpart F is primarily directed at two types of income: passive investment income and income derived from dealings with related corporations. Both of these types of income may be easily movable from one taxing jurisdiction to another.

Although the nuances of subpart F are extremely complex (and beyond the scope of this item), the basic operation is fairly simple: certain U.S. taxpayers are denied deferral treatment and instead are taxed directly on certain income earned by controlled foreign corporations (CFCs). CFCs are defined as foreign corporations in which U.S. shareholders own more than 50% of either the stock's combined voting power or its value (Sec. 957(a)). A "United States shareholder" is a U.S. person owning at least 10% of the voting power of the corporate stock (Sec. 951(b)).

In addition to a ratable share of subpart F income, a U.S. shareholder must include in gross income its pro rata share of any increase in the CFC's investment of earnings in U.S. property. Generally, earnings brought back to the United States in this manner are taxed to the shareholders because this is substantially equivalent to a paid dividend (Secs. 951(a) and 956(a)).

In general, U.S. property includes (1) tangible property located in the United States, (2) stock of a domestic corporation, (3) an obligation of a U.S. person, or (4) any other right to use in the United States a copyright, patent, invention, model, design, formula, process, or similar property right the CFC acquired or developed for use in the...