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You Weigh In: Is the IRS Wrong on CFC Status?

Posted on Jan. 20, 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 argues that the IRS incorrectly concluded that a domestic shareholder held all of a foreign corporation’s voting power, and thus incorrectly treated the foreign corporation as a controlled foreign corporation.

I believe the IRS incorrectly concluded that a domestic shareholder that held exactly half of a foreign corporation’s voting power held all of it, and thus treated the foreign corporation as a controlled foreign corporation. The IRS reasoned that the domestic corporation has the power to “readily force” the foreign corporation into liquidation. If the IRS is wrong, the ruling should be obsoleted or taxpayers will continue to rely on this ruling for what practitioners have called negative voting power.1

Reasonable minds disagree all the time when analyzing tough tax questions because these issues can be incredibly taxing. You can offer your opinion on whether you think a CFC was created in Rev. Rul. 70-426, 1970-2 C.B. 157 (see exhibit 1 for an illustration) by emailing me.

Rev. Rul. 70-246

In Rev. Rul. 70-426, Y, a foreign corporation, has 200 shares of stock outstanding, with a domestic corporation, X, owning 100 shares of class A stock and two foreign individuals each owning 50 shares of class B stock. The class A shares have no par value, and the class B shares have a $1 par value.

Each class of outstanding stock has the same voting rights. The length of Y’s corporate charter is one year, with an annual renewal that requires approval by the shareholders owning 75 percent of the combined voting power of all classes of stock entitled to vote.

The ruling provides that “X, owning 50 percent of the total combined voting power of Y, has the power to readily force Y into liquidation.” Because Y’s charter has a one-year life that requires shareholders holding 75 percent voting power to approve a renewal, the ruling concludes that X is deemed to own the voting power ostensibly held by the foreign shareholders. That logic is flawed: Y will liquidate if X does not act and there is no indication X or the shareholders engaged in any behavior to shift voting power.

The purpose of this corporation might very well be completed within a year, and there are no facts providing otherwise. Corporations are often designed to accomplish special purposes. The question regarding the desire to retain the corporation’s existence could be moot by the end of the year. The same logic and principles in this ruling would apply regardless of the corporation’s scheduled expiration, whether it be one year or 20 years.

The value of the stock, based on a right to a par value or a preference on dividends, does not affect its voting power. While this is true generally, at the time of the ruling, section 957(a) based CFC status on a more-than-50-percent voting power threshold. It wasn’t until 1986 that Congress added the section 552 (foreign personal holding company) value threshold to section 957(a) to create the more-than-50-percent vote or value threshold. Similarly, the 10 percent vote or value threshold in the section 951 definition of a U.S. shareholder didn’t exist until the Tax Cuts and Jobs Act added the value component in 2017.

Since the early 1960s, reg. section 1.957-1(b) had used a voting power standard based on dominion and control under all the facts and circumstances. The regulations targeted abuse through shareholder shifts of voting power to escape subpart F. And then, like now, reg. section 1.957-1 ensured those determinations took into consideration whether there was a principal purpose of tax avoidance. But there was no tax avoidance purpose in Rev. Rul. 70-426.

The revenue ruling at issue involves no shareholder attempts to shift voting power. The party that the IRS concluded has 100 percent control, X, can’t unilaterally change how the business is set to operate and be managed. X has only half of the power to implement managerial control of the corporation, with common rights such as voting for directors, and through those directors determining how to satisfy the enterprise’s purpose and how to conduct management. The domestic and foreign shareholders each own half of the voting power.

In concluding that there was a CFC based solely on voting power, the IRS looked to a single factor: X’s choice to allow the corporation to liquidate in line with its purpose in accordance with the charter. In other words, if X allowed the corporation to liquidate by doing nothing at the end of a year, as it was designed to do via the charter, the IRS would view it as if X readily forced Y into liquidation. There is no evidence that this could have been valuable to X and, in fact, extending the period of the corporation’s existence beyond the set expiration could very well impose additional and unnecessary costs on Y and its shareholders.

The ruling explores reg. section 1.957-1(b)(1), which provides that the voting power held by U.S. shareholders is determined by considering all facts and circumstances, and that those shareholders will be deemed to have more than 50 percent of the voting power of a foreign corporation if they have either: (1) the power to elect, appoint, or replace a majority of the board of directors; (2) the power to break a deadlock, when U.S. shareholders have the power to elect exactly one-half of the directors; or (3) the power to elect, appoint, or replace a single person, such as a managing partner, who exercises the powers ordinarily exercised by a board of directors. Based on the ruling’s facts, the U.S. shareholder, which has rights to voting power that are identical to the foreign shareholders’ rights, does not meet any of those thresholds.

The ruling finally explores reg. section 1.957-1(b)(2), which provides that any arrangement to shift formal voting power away from U.S. shareholders of a foreign corporation, including any express or implied agreement, won’t be given effect if — in reality — voting power is retained. There was no such arrangement. These provisions also address situations in which voting power is substantially greater than rights to earnings, voting rights are not exercised independently, or if a principal purpose of an arrangement was to avoid classification as a CFC. None of this applies to this ruling and would have altered X’s voting power.

OK Ben, you ask, so what could the IRS have been basing its conclusion on? Well, we’re back at dominion and control based on the facts and circumstances under reg. section 1.957-1(b)(1). X is the only person that can, alone, block the other shareholders from choosing to renew the corporation’s existence. The IRS is effectively viewing X as having a veto right to prevent the 50 percent foreign shareholders from choosing to prevent the charter’s scheduled liquidation of Y. The only way the IRS can argue that the ruling is correct is if a veto right to prevent a corporation from undertaking its charter’s scheduled liquidation alters the percentage of voting power that the veto holder has.

But X can’t make the foreign shareholders vote their shares the way X wants; if X did, that would create a CFC through an arrangement to shift voting power under reg. section 1.957-1(b)(2) — and the facts do not support that. There is no veto right, and the charter requires 75 percent voting to extend the life of Y. X is not taking voting power away from the shareholders that own 50 percent of it.

Negative voting power has not been created because of thresholds set by the charter. X simply cannot do more than the charter allows, and neither can the foreign shareholders.

If the two foreign shareholders are one, the outcome should remain the same. X would still be able to prevent the other shareholder from renewing the corporation’s existence, just as the other shareholder could do to X. Under the logic of the ruling, if there were five foreign shareholders each holding 10 percent of the voting power, X, who would own 50 percent of the voting power, would be treated as owning all their voting power if the renewal required more than 50 percent voting power. The IRS cannot create an agreement among shareholders that did not occur.2

The reason the IRS provided for its conclusion, that the shareholder can readily force the foreign corporation into liquidation, which is consistent with the charter, is faulty. X, as the U.S. shareholder, and the foreign shareholders have equal voting rights, and neither can force the other to renew the corporation’s existence; and if there exists any agreement among the parties that would alter the vote they would independently make, the section 957 regulations could be relied on to alter their voting power to align with reality.

But perhaps I am wrong. Do you think Y should be a CFC in Rev. Rul. Rul. 70-426? Let me know — I want to hear from you.

FOOTNOTES

1 See Marc M. Levey and Lawrence A. Pollack, “Should Your Foreign Corporation Be a CFC?” 1 J. Int’l Tax’n 204 (Nov./Dec. 1990).

2 Cf. Estate of Weiskopf v. Commissioner, 64 T.C. 78 (1975), aff’d per curiam, 538 F.2d 317 (2d Cir. 1976) (finding a CFC when the U.S. shareholders owned 50 percent of the shares of the foreign corporation and, through a separate shareholder’s agreement outside the articles of organization, also controlled the supply of the main product line, and the U.S. shareholders held a deadlock right in their favor).

END FOOTNOTES

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