IRS Determines That Controlled Foreign Corporation Structure Is "Transaction of Interest"

Summary

In IRS Notice 2009-7, the IRS formally designated a particular structure involving controlled foreign corporations (CFCs) as a "transaction of interest." Taxpayers with structures the same as or substantially similar to the one described in the Notice must be disclosed by taxpayers entering into those transactions or structures on or after November 2, 2006, pursuant to Treas. Reg. 1.6011-4(b)(6). In addition, "material advisors" with respect to those transactions or structures may have disclosure and list maintenance obligations (under Sections 6111 and 6112, respectively). Classifying these structures or transactions as transactions of interest requires taxpayers and their advisors to implement reviews and reporting for structures or transactions entered into more than two years ago.

The structure that the IRS has now identified as a transaction of interest involves the following: A U.S. taxpayer (UST) wholly-owns two CFCs (CFC-1 and CFC-2), which in turn are the sole partners in a U.S. partnership (P). P, which is said not to be "subject to U.S. tax," in turn owns all the stock in CFC-3, which earns income described in Section 952 (Subpart F income).

The IRS has also included some variants of the above structure in the Notice, such as (1) there may be more than one person who owns stock in CFC-1 or CFC-2, (2) P may own less than 100 percent of CFC-3, (3) a domestic trust may be used instead of P, or (4) the "Subpart F income" of CFC-3 could also be amounts includable under Section 951(a) pursuant to Section 956.

The IRS has identified the foregoing structures/transactions and those substantially similar thereto (not limited to the four variants provided in Notice 2009-7) because it claims that "taxpayers are taking the position that [the] structures described in Notice 2009-7 result in no income inclusion to [UST] under Section 951." There is no analysis in the Notice regarding this purported erroneous taxpayer treatment of these structures or transactions.

Comments

• It appears taxpayers and their advisors were trying to use a hypertechnical reading of the term "person" (which is defined in Section 7701(a)(1) to include a "partnership"), so as to say that once stock in CFC-3 is owned by P (a U.S. partnership, hence a U.S. person, thus qualifying as the "U.S. Shareholder" of CFC-3), UST was asserted to be "blocked" from having to report deemed income under Section 951. However, the IRS is apparently saying that this approach artificially truncates the analysis since income earned by CFC-3 that constitutes Subpart F income when deemed included by P retains that character when it is passed through to CFC-1 and CFC-2 under the partnership rules. Because P owns all of CFC-1 and CFC-2, they in turn are reportable CFCs by P. Income deemed received by P whose character is Subpart F income already would appear to retain that same character in the hands of those two CFCs when passed through under the K-1, and thus would be deemed included by and reportable by UST as the sole U.S. Shareholder of those two CFCs. In short, the only actual—and proper—U.S. taxpayer here is UST.
• It is not clear what the IRS means when it said that P "is not subject to U.S. tax." For example, is this merely the IRS espousing the view that a partnership does not, per se, pay tax itself (and in that sense the IRS is applying the "aggregate" theory of partnerships)? If so, then their inclusion of the "domestic trust" alternative seems anomalous since trusts are, in fact, separate taxpayers. Thus, a nongrantor U.S. trust could be a U.S. Shareholder under the Subpart F rules, with required CFC reporting and deemed income inclusion itself with respect to the Subpart F income realized by CFC-3. Similarly, though not specified in the ruling, the substitution of a U.S. LLC instead of a partnership should not alter the impact of or analysis underlying the Notice since U.S. multimember LLCs are considered partnerships as their default classification.
• U.S. partnerships that are "engaged in trade or business" in the U.S. result in their partners being considered so engaged under Section 875(1). Accordingly, CFC-1 and CFC-2 could have direct filing obligations themselves (on Forms 1120F) with respect to income effectively connected with the U.S. trade or business ("ECI") being conducted by P. Note that ECI can be U.S. source or foreign source income, so more facts about what P actually does would be needed.