New Tax Act: 2017 Trap for 10% U.S. Owners of Foreign Corporations

by Mark A. Ziemba, Carlene Y. Lowry and Soheila Shahidi

The Tax Cuts and Jobs Act of 2017 (the “Tax Act”) modifies Section 965 of the Internal Revenue Code (“IRC”) by expanding the definition of “subpart F income” of United States shareholders (“U.S. shareholder”) for the last tax year beginning before January 1, 2018 (“2017 Tax Year”). IRC Section 965 generally requires U.S. shareholders of certain foreign corporations to include in income in the 2017 Tax Year post-1986 earnings and profits that are not otherwise attributable to income which is subject to U.S. tax as “effectively connected income” and that has not been previously taxed as subpart F income. In order to determine the proper inclusion, U.S. shareholders may need to consider the direct, indirect and constructive ownership of U.S. shareholders in the foreign corporation back to 1986 and the constructive ownership through foreign persons for the 2017 Tax Year, as described further below.
 
IRC Section 965 applies to Specified Foreign Corporations (“SFC”). An SFC includes a controlled foreign corporation (“CFC”), which is the common starting point for CFC subpart F income. In addition, however, an SFC also includes a foreign corporation that is owned at least 10% (by vote, for years before 2017, or also value for 2017) by a U.S. corporation. Ownership determinations for CFCs have always included the IRC Section 318 constructive ownership rules. For the 2017 Tax Year, however, the application of the constructive ownership rules to SFCs creates subtle and surprising results.

One result is caused by the fact that, under the constructive ownership rules of IRC Section 318(a)(3)(C), a U.S. corporation owned at least 50% by a shareholder is deemed to own the stock owned by that shareholder in a foreign corporation. If the shareholder is a U.S. person, the attribution to the U.S. corporation of the U.S. shareholder’s ownership interest in the foreign corporation occurred prior to the Tax Act, but it previously did not matter if the attribution did not create a CFC. Now, however, the attribution of as little as a 10% ownership interest in a foreign corporation to a U.S. corporation creates a SFC (despite the U.S. corporation having no actual ownership in the foreign corporation). Further, such constructive ownership will result in the foreign corporation having been an SFC for as long as the U.S. person has been a U.S. shareholder in the foreign corporation while simultaneously owning at least a 50% interest in the U.S. corporation (back to 1986).

Thus, the actual U.S. shareholder in the SFC may have additional income in the 2017 Tax Year merely by having been a U.S. shareholder in the foreign corporation in 2017 while simultaneously holding a 50% or greater interest in a U.S. corporation. The calculation of the income to include in the 2017 Tax Year requires that the U.S. shareholder know all tax years during which the foreign corporation was an SFC (back to 1986). In addition, the SFC could have been an SFC as a consequence of the ownership of any U.S. shareholder, not just the U.S. shareholder at issue. Thus, in addition to analyzing their own ownership in U.S. corporations, U.S. shareholders may also need to perform an ownership analysis in relation to other U.S. shareholders back to 1986 in order to determine all years in which the foreign corporation was an SFC.
 
In addition, the Tax Act eliminated IRC Section 958(b)(4) starting with the 2017 Tax Year. This section previously prohibited IRC Section 318(a)(3)(C) from attributing stock held by a foreign person to a U.S. corporation. Because such attribution is now possible, a U.S. shareholder in a foreign corporation may also need to analyze whether the constructive ownership rules create an SFC for 2017 through foreign owners in the same foreign corporation.