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You’ve Weighed In: Reading Between the Lines of CFC Status

Posted on Feb. 17, 2020
Benjamin M. Willis
Benjamin M. Willis

Benjamin M. Willis (@willisweighsin on Twitter; ben.willis@ taxanalysts.org) is a contributing editor for Tax Notes Federal. He previously worked in the mergers and acquisitions and international tax groups at PwC, and then with the Treasury Office of Tax Policy, the IRS, and the Senate Finance Committee. Before joining Tax Analysts, he was the corporate tax leader in the national office of BDO USA LLP.

In this article, Willis reviews observations from the poll results of his last three articles on controlled foreign corporation status and asks readers to choose one of four topics he can address in upcoming articles.

Our first poll on Rev. Rul. 70-426, 1970-2 C.B. 157 (see diagram), in which roughly nine in 10 voters disagreed that a controlled foreign corporation was created, told us that readers did not think that negative voting power stemming from a charter should result in more CFCs.1

Our second poll on Rev. Rul. 82-150, 1982-2 C.B. 110 (see diagram), could indicate being deep in the money on an option is a strong factor in determining whether an option should be treated as exercised. While the IRS concluded that a domestic holder of a deep-in-the-money option currently owned stock in a foreign corporation it could obtain by paying a $30,000x strike price, voters were roughly split 50/50 on whether a court would find the IRS holding credible based on the ruling’s facts and analysis. This could reduce the number of CFCs because various options could be created to fall in or out of the stock ownership factors for CFC status.2

Rev. Rul. 70-426
Rev. Rul. 82-150

The third poll on Rev. Rul. 83-23, 1983-1 C.B. 82 (see diagrams), could indicate that an event that compels a decontrolling event should be a good purpose to engage in a spinoff (or other transaction) to decontrol a new CFC created because of that event. In other words, the voters value that ruling, which could obviously result in fewer CFCs or at least more decontrolled CFCs.3 This was clear because roughly 70 percent of voters sided with the IRS.

Collectively, the results could be viewed to show that voters want to be able to turn off CFC status when desired. Of course, this is simply a guess because no one knows why voters vote the way they do. And I’ll posit some points below that could lead to other interpretations.

Voting power for control is considered held by U.S. shareholders, actual or deemed, that exercise voting control, even if they may lack formal ownership of a majority of the corporation’s voting stock.4

For example, as explained by the IRS in FSA 200202057: “Rev. Rul. 85-87, 1985-1 C.B. 268, treats a taxpayer that sold a significantly in-the-money put as entering into a contract to buy the shares. The revenue ruling determined there was no substantial likelihood the put would not be exercised based on the term of the put, the premium paid, the historic volatility in the value of the stock, and the difference between the strike price of the put and the price of the shares at the time the put was entered into.” The IRS looked to seven factors in the field service advice to determine whether the benefits and burdens of ownership shifted. But that revenue ruling did not address subpart F. And even though the revenue ruling also looked at several factors other than the option being deep in the money, every code provision must be looked to in determining the appropriate degree of substance and form to be applied. Some incorporate rules that treat an option as exercised and some do not.

Rev. Rul. 83-23 (Steps 1 and 2)
Rev. Rul. 83-23 (Step 3)

Further, reg. section 1.958-2 now provides that the ownership of an option is the equivalent of owning the underlying stock. While this rule had no part in Rev. Rul. 82-150, it sheds light on the principles of that ruling. Because subpart F targets income that taxpayers have historically sought to defer, the breadth of these regulations brings an understanding that CFC determinations are more akin to antiabuse thresholds than those that are now generally elective, such as the section 80 percent vote and value test of section 1504 used for consolidated groups and electivity between sections 331 and 332 liquidations. Further, the poll question on Rev. Rul. 82-150 was based on a court’s determination and did not require that the answer be addressed based on the historic principles the IRS was obligated to follow in that ruling.

Filling in the Gaps — Case Law

Because ownership of more than 50 percent of a foreign corporation’s vote or value by U.S. shareholders triggers the loss of deferral for some corporations, which could be relevant for new as well as old corporations under post-Tax Cuts and Jobs Act law, joint ventures with foreigners continue to allow for some electivity of subpart F treatment. While reg. section 1.957-1 implicates substance over form, the courts have also adopted an approach based on actual dominion and control. And taxpayers can respect that with various tools, as case law shows.

One could view a threshold based on control as follows: Do U.S. shareholders have the ability to defer foreign income by preventing the distribution of a dividend?5 While such a determination is generally made by the majority of a board of directors, that is not always the case. Thus, a high-level review of the key cases on this topic is warranted.

In Garlock,6 an American corporation decontrolled a Panamanian corporation by issuing stock with a preference to receive a fixed annual cumulative dividend at 8 percent with one vote per share. Regarding section 957 control, the Tax Court explained:

The concept that mechanical or formalistic compliance with the statute is sufficient has long been rejected by the courts. . . . The basic purpose of the 50-percent test in section 957(a) was clearly designed and intended to exclude from the definition of a ‘controlled foreign corporation’ only those foreign corporations which were not subject to the dominion and control of U.S. shareholders. To enable or to allow U.S. taxpayers to overcome this basic statutory purpose through the issuance of stock certificates to accommodation buyers, without in substance relinquishing control of the foreign corporation, would frustrate the intent of the Congress. [Emphasis added.]

The Second Circuit agreed with the Tax Court and pointed to the following statement to show that control remained with the U.S. shareholders: “with foreign investors who understand our motives and are willing to vote their stock with us in return for an ample dividend rate.”7 The court determined voting power should be interpreted broadly in line with the abuses Congress sought to avoid by enacting subpart F.

In Kraus,8 the Tax Court and lower court held that foreign holders of 50 percent of a corporation’s voting stock did not have 50 percent of the voting power in part because the foreign holders had an understanding with the U.S. shareholders that they had dominion and control. The circuit court explained:

Although the common stock [held by U.S. shareholders] was in bearer form and freely transferable, the preferred stock [held by foreign shareholders] was registered and transfer was permitted only with the approval of the board of directors. Transfer could be prohibited for ‘important reasons’ and there was no definition or suggestion as to what such reasons might be.”9

This indicated the foreign shareholders were needed to avoid CFC status.

In Weiskopf,10 the court found a CFC when the U.S. shareholders that owned 50 percent of the shares of the foreign corporation also, through a separate shareholder’s agreement outside the articles of organization, controlled the supply of the main product line, and the U.S. shareholders held a deadlock right in their favor. The court said the U.S. shareholders “Whitehead and Weiskopf retained control and dominion over Ininco despite Romney’s 50-percent voting rights” because of their “complete and unfettered control by Limited over Ininco’s only product line, the AutoAnalyzer.”11

In Textron,12 the Tax Court held that a beneficial interest in voting trust was sufficient to create a CFC with the trust as the shareholder, and not its forming corporation. In early 1989, Textron acquired nearly all the stock of Avdel, organized under the laws of the United Kingdom and traded on the London Stock Exchange. On February 21, 1989, the Federal Trade Commission obtained a temporary restraining order providing that Textron was “temporarily restrained and enjoined from assuming or exercising any form of direction or control over the assets or operations of Avdel.”

While Textron was considered to own those shares under section 958(b), it did not own those shares either directly or indirectly within the meaning of sections 951(a) and 958(a). The court rejected the IRS’s attempted application of section 677(a)’s grantor trusts constructive ownership rules. Thus, the court held that the trust was the owner and, as the grantor of the trust, Textron was required to include all the trust’s subpart F income. The conclusion makes sense as the trust was set up to ensure that Avdel competed with Textron as if they were unrelated based on antitrust laws.13 While ultimately the IRS was able to allocate the subpart F income to Textron under the trust rules, the case illustrates limitations of the ownership requirements.

In CCA,14 the Tax Court held for the taxpayers on a section 957(a) decontrol transaction. In CCA, “old CCA” was a Delaware corporation with headquarters in Illinois. In 1958, old CCA incorporated Control AG as a wholly owned Swiss corporation with a principal office in Zug, Switzerland. In 1963, old CCA decided to decontrol Control AG for purposes of section 957(a) by divesting itself of 50 percent of the voting rights of Control AG. After a recapitalization, Control AG had two classes of stock, common and preferred, with each class holding 50 percent of the voting rights of Control AG. Old CCA held all the common stock, and non-U.S. shareholders owned all the preferred stock.

The Control AG board was evenly split between five directors elected by old CCA and five directors representing the preferred shareholders. Under Swiss law, only shareholders had the power to declare dividends through a shareholder vote. The owners of voting stock, including both common and preferred, also had the right to vote on registration of share transfers. Under Swiss law, any two directors had the “signature power” to bind the corporation. The court concluded there were no express agreements or understandings, whether written or oral, regarding how the preferred shareholders would vote their shares. The court explained:

What was lacking in the Weiskopf, Kraus and Garlock cases was any real opportunity to alter the course of events by the preferred shareholders. In this case, the preferred shareholders had, by virtue of the powers which they possessed, a real opportunity to alter the course of events of the corporation if they desired to do so.

Similarly, in Framatome,15 the Tax Court held that a 50 percent U.S. owner lacked the control, in substance, necessary to cause a foreign joint venture to be a CFC. In reaching this conclusion the court explained:

Burndy-US does not meet the requirements of section 1.957-1(b)(1) [because it] . . . lacked the power to elect, appoint, or replace a majority of the board of directors . . . it lacked the power to break tie votes and could not unilaterally exercise powers ordinarily exercised by a domestic board of directors . . . [and] because the veto powers and supermajority requirements prevented Burndy-US from exercising powers over Burndy-Japan ordinarily exercised by a domestic board of directors. . . . [Therefore,] we conclude that Burndy-US did not own more than 50 percent of the voting power of Burndy-Japan in 1992.16 [Emphasis added.]

Conclusion

Reading between the lines of the poll results on the three revenue rulings above is nearly impossible. The reasoning for the differences could be temporal. Law changes based on options, for example, could lead one to ignore the benefits and burdens of stock ownership and look to the current rules on options. That said, one could also view the poll results as showing that revenue rulings that make it more likely to create CFCs, and thus deemed dividends, are unfavorable, and that those giving flexibility, as in the middle, and those allowing fewer CFCs through decontrolling transfers are favorable.

Further, many view revenue rulings as elective; that is, the IRS must follow them, but courts can consider them interpretive guidance and easily distinguish them if there is a minor change in facts.

This brings me to the poll question for this article. Which of the following would you like to vote on in future articles: (1) more revenue rulings, (2) cases, (3) regulation examples, or (4) new revenue rulings (of the author’s design)?

Rev. Rul. 2019-24, 2019-44 IRB 1004, determined that a hard fork of new virtual currency is a taxable event. I could draft a new revenue ruling involving a fork of a new virtual currency that I don’t think is a taxable event. That said, I’m open to suggestions and ask that you vote on what you’d like to see next. Your votes are anonymous, and this poll will allow voters to determine what they’d like to read next. [Editor's Note: The poll for this article is now closed. If you have other suggestions, contact Ben.]

FOOTNOTES

1 Benjamin M. Willis, “You Weigh In: Is the IRS Wrong on CFC Status?Tax Notes Federal, Jan. 20, 2020, p. 415.

2 Willis, “You Weigh In: Is the IRS Wrong on U.S. Shareholder Status for CFCs?Tax Notes Federal, Jan. 27, 2020, p. 597.

3 Willis, “You Weigh In: Is the IRS Wrong on Decontrolling CFC Spinoffs?Tax Notes Federal, Feb. 3, 2020, p. 773.

4 See Commissioner v. First Security Bank of Utah, 405 U.S. 394, 403 (1972) (citing Corliss v. Bowers, 281 U.S. 376, 378 (1930), the Court found “complete dominion” over the income to be the appropriate test for determining the constructive receipt of income).

5 The 1962 Senate Finance Committee report noted that “generally, earnings brought back to the United States [under subpart F] are taxed to the shareholders on the grounds that this is substantially the equivalent of a dividend being paid to them.” S. Rept. No. 87-1881 (1962).

6 Garlock Inc. v. Commissioner, 58 T.C. 423 (1972), aff’d, 489 F.2d 197 (2d Cir. 1973), cert. denied, 417 U.S. 911 (1974).

7 Garlock, 489 F.2d 197.

8 Kraus v. Commissioner, 490 F.2d 898 (2d Cir. 1974), aff’g 59 T.C. 681 (1973).

9 Kraus, 490 F.2d 898.

10 Estate of Weiskopf v. Commissioner, 64 T.C. 78 (1975), aff’d per curiam, 538 F.2d 317 (2d Cir. 1976).

11 Estate of Weiskopf, 64 T.C. 78.

12 Textron Inc. v. Commissioner, 117 T.C. 67 (2001).

13 See Rev. Rul. 66-23, 1966-1 C.B. 67, in which a court decree based on antitrust laws designed to ensure competition required shareholders receiving stock in a merger to dispose of the shares in any manner desired within seven years. The IRS held that continuity of interest was met even though the jurisdictional law effectively created a binding commitment to dispose of stock, allowing that it left the form of the disposal up to the owners. Practitioners historically looked to this ruling for a five-year limit on step transaction generally because the IRS stated in the ruling: “Ordinarily, the Service will treat 5 years of unrestricted rights of ownership as a sufficient period for the purpose of satisfying the continuity of interest requirements of a reorganization.” This ruling was obsoleted after the holding period of stock ownership for continuity of interest became irrelevant in the section 368 regulations beginning in 1998. Cf. Rev. Rul. 83-23, which was viewed as creating a binding commitment, but no time period was provided.

14 CCA Inc. v. Commissioner, 64 T.C. 137 (1975).

15 Framatome Connectors USA Inc. v. Commissioner, 118 T.C. 32 (2002).

16 Id. at 61.

END FOOTNOTES

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