|
Back in the early 1980s, when I began my research of the US Tax Code, (more specifically international taxation and tax havens) I believed it would be a good foundation for future business endeavors.
Lawyers, tax professors and tax practitioners that live with the tax code on a daily basis are at least the most misunderstood and probably neurotic people in the world.
How could anyone enjoy “trolling” through complicated “code” and “formulas” that forever run around in your minds 24 hours a day, even as they sleep? Understanding what the lawmakers and tax writers with the US Treasury Department (including enforcement via the IRS) promulgate into law for us to fandom is drudgery at least, and impossible “sledding’ for the average taxpayer.
Controlled Foreign Corporations and Passive Foreign Investment Companies PFIC).
Until recently there were five (some claimed six) stumbling blocks that made “going offshore” especially complicated and “taxing” for the US taxpayer. One professor in the 1980s called these sections of the tax code a “pentapus” of trouble, ultimately causing tax problems and liability for the US taxpayer.
The five/six arms of the pentapus of the IR Code regarding foreign investment included the following Code sections:
1. A Personal Holding Company under Code/Sections § 541-547
2. A Foreign Personal Holding Company under Code/Sections §§ 551-558
3. A Controlled Foreign Corporation under Code/Sections §§ 951-964
4. A Foreign Investment Company under Code/Sections § 1246-47
5. A company subject to the accumulated earnings tax under Code/Sections § 531-537
6. A Passive Foreign Investment Company provisions (Code/Sections §1291-1297).
Recently, the US tax code repealed the Foreign Personal Holding Company provisions that date back to the 1930s because they overlapped other provisions and had become “obsolete”.
Repeal of FPHC Rules in 2004
The American Jobs Creation Act of 2004 repealed the foreign personal holding company rules for tax years beginning after Dec. 31 2004. Before repeal, a U.S. shareholder of a foreign personal holding company had to include in income a share of any of the company's foreign personal holding company income that remained undistributed at the end of the company's tax year. The foreign personal holding company (FPHC) rules did not directly impose a tax. Rather, they increased the amount of income of a U.S. shareholder that was subject to U.S. income tax.
The main obstacles for the US taxpayer that remain daunting.
But two obstacles for US taxpayers wanting to use tax havens remain troublesome. These are the Controlled Foreign Corporation provisions under § 951-964 and the Passive Foreign Investment Company provisions (Sections § 1291-1297). Navigate free of these tax rules and the US taxpayer might by-pass indirect taxation, and be on par with the “non-resident alien” – who does not have any exposure to these draconian provisions because they are not US taxpayers or citizens.
Ironically, for both these sections of the United states Tax “Code” to create a tax liability, you have to be a shareholder in the offshore company.
A Heretofore HIDDEN LOOPHOLE in the PFIC and CFC provisions????: Being solely a “bondholder” in the offshore company would not create any US tax liability because under the law only “shareholders” can incur a US tax liability. Note, as a bondholder, you would have to report and pay tax on the interest paid on the company bond/debenture. But, there is no ‘threshold” for how low that interest rate must be. The foreign corporate bond could theoretically yield less than 2% interest annually, and would not breach any tax code limits.
For example, under the Controlled Foreign Corporation provisions under § 951-964, if you are not by definition a “US shareholder”, you don’t have to put the passive, subpart F income of the Controlled Foreign Corporation on your tax return.
The IRS often has a lot to prove to the federal tax “judge”.
Also, if the offshore company is not a Controlled Foreign Corporation (defined below), you would not have a tax liability even if you are a US 10% voting stock holder”.
Not all shareholders are liable for tax, so if you avoid certain thresholds of stock ownership, the IRS might let you escape all indirect taxation even if you are a shareholder in the offshore company.
A U.S. person is deemed to be a "U.S. Shareholder" if he owns or controls 10% or more of the voting stock of the foreign corporation. A "Controlled Foreign Corporation" is one where more than 50% of its value or voting stock is owned by "U.S. Shareholder(s)".
The distinction between a "U.S. person" and a "U.S. Shareholder" is an important one. Only U.S. Shareholders are restricted from electing, appointing, or replacing directors, and then only a majority of those directors.
Note, we are only determining the prerequisite for a “US shareholder under at § 951(b), and not whether the offshore company is a Controlled Foreign Corporation under 957(a).
The offshore company also has to be a CFC for the “US Shareholders” to have a tax liability.
Definition of a CFC
In general, a foreign corporation is a CFC if at least 50% of either the total voting power or total value of the stock of the foreign corporation is owned by U.S. persons, each of whom owns at least 10% of voting power of the corporation (each such U.S. person a "10% ("voting stockholder is the term the Tax Code uses under IRC 951(d) Shareholder"). Note that the type of income or assets of the corporation does not affect whether a foreign corporation qualifies as a CFC, but those attributes will affect how much income is taxable to the 10% Shareholders under the CFC rules.
Consequences to U.S. Shareholders of a CFC
The 10% (voting stock) Shareholders of a CFC are taxed on their share of the corporation's "Subpart F Income" whether or not this income was distributed. But note, the offshore company must be a CFC too.
Subpart F Income generally includes interest, dividends, rents, royalties, and business income derived from transactions with related parties unless the business in conducted entirely within the country in which the CFC is organized. The 10% Shareholders of a CFC must also include their share of certain amounts of previously untaxed income which is invested in U.S. property and certain amounts of previously untaxed income which is invested in so-called "excess passive assets".
As with the other anti-deferral regimes, the CFC rules can cause a cash-flow problem for Ten Percent Shareholders who are taxed on income which is not distributed to them by the corporation.
Avoiding the CFC thresholds for the small, medium or large size investor is a must to avoid all incidents of US taxation.
EXAMPLE: US person A owns 4% of the voting stock in a closely held Cayman Exempt Company X, and another 4% of the non-voting stock of X.
Under these conditions, US person is not a “US shareholder” because he doesn’t own the prerequisite amount of stock in Cayman Company X, and X is not a CFC because there are no US Shareholders that own “more than 50%” of Cayman company X.
US person A could generally be described as a “minor” shareholder in a non-controlled foreign corporation, and as such would not have to report his holding on form 5471 and would not have a tax liability on “any” of the offshore companies earnings.
But note, Cayman Company X could not have an office or be doing business inside the US, or it would have to file tax returns the same as any domestic U.S. company.
"One of the most effective applications of offshore trusts is in an ownership combination with a limited company." - Richard Graham-Taylor, partner Ernst & Young, Grand Cayman (January 1990).
In 2005, Ernst & Young reported worldwide revenues in excess of 18 billion dollars.
Authors final comment: While "bonds" have potential useful application in side stepping indirect taxation under the CFC and PFIC provisions, the bonds cannot be "convertible bonds" (i.e., redeemed for stock) or the IRS will certainly characterize the "bonds" as "stock"
Pursuant to Internal Revenue Service guidance, be advised that any federal tax advice in this communication, including any attachments or enclosures, was not intended or written to be used, and it cannot be used, by any person or entity for the purpose of avoiding penalties imposed under the Internal Revenue Code.
|
Favoured: 0
