Direct Investment Abroad
Alternative foreign investment situations:
Cf., direct vs. portfolio investment
Alternative direct investment structures:
1) Foreign branch of a U.S. corporation
(or a foreign branch of a U.S. subsidiary)
2) Foreign destination country subsidiary
3) Third country (foreign) subsidiary (& branch
of that 3rd country sub in the destination country?)
Foreign Branch Options
Use (i) U.S. parent corporation or (ii) a special purpose U.S. (or
of a U.S. corporation will enable U.S. tax deductions, e.g., (i) minerals and
oil and gas exploration, and (ii) consolidated return treatment (loss
utilization, but subject to later “recapture”).
No limitation of commercial liability for foreign branch assets –
but, use a special purpose U.S. subsidiary to hold only this investment.
Use of “start-up losses” for U.S. income tax.
Foreign Branch Options, cont.
What risk of exposure to the foreign country tax system?
Possible to avoid P.E. status in destination country if (1)
Applicable bilateral income tax treaty, and,
(2) Limited contacts with the destination country (e.g., trading
Use of a Foreign Business
If a foreign country corporation is used:
1) Corp is subject to income tax in that country.
2) Less complication in forming a foreign country
corporation than a foreign country branch?
What other local country benefits and restrictions?
E.g., (1) compliance with local corporate law, such as who are
shareholders and directors; and (2) commercial liability risks are less with a
foreign country subsidiary?
Use of a Foreign Business Organization,
If a foreign corporation is used, deferral of U.S. income tax is
available, assuming inapplicability of Subpart F (e.g., significant deferral if
active business operations occur & tax holidays are available in the
Organization of a foreign corporation may accommodate foreign
What form of foreign business entity should be used to
enable corporate status there? LLC?
Use a “hybrid entity” or a corp. in the foreign country? Use
a one owner “disregarded entity”?
Western (US) is engaged in U.S. mining.
Planning a mining venture in Country Z.
Initial capital of $300 million in equity.
Terms of the “deal” in the foreign country:
1) royalty to be paid for the mineral product;
2) foreign income tax of 30% on net profits;
3) no withholding tax on div. or royalties paid;
4) deduction for process patent royalty paid.
See next slide.
Use (1) a branch of the U.S. corporation or (2) a foreign
corporation (in destination country)?
Maintain eligibility for the percentage depletion deduction for
U.S. income tax purposes? Probably.
Prompt profitability for the project, i.e., no need to utilize
losses for U.S. tax purposes.
Setting the Royalty Amount
Establish the royalty amount for the process payment at (1) the
low end ($5 million) or (2) the high end ($10 million)?
Reduction in the royalty reduces the U.S. income tax to Process by
35% of the unpaid royalty amount and the Country Z tax only increases by 30%
(5% tax rate differential).
I.e., “arbitraging the tax rates”?
foreign country income tax rate.
Other foreign branches with 25% average foreign tax rate.
royalty amount for the process patent.
Foreign country project organized as a branch.
Foreign tax credit effects?
Assume other foreign mining ventures and anticipated excess
foreign tax credits for foreign source residual basket of $5 million.
Tax Characterization of the Foreign
Necessary to have limitation of liability through the use of an
Use a corporation or a (non-corporate) LLC?
Necessary to have two or more owners for an LLC? Use two
special purpose subs in the U.S. to hold 50% (or 90 & 10%?) interests in
Deferral is not important if the foreign income tax rate is as
high as or higher than the U.S. income tax rate.
Entity Choices Outside the
Foreign corporation in the host country (and similar foreign
Third country corporation.
Limited liability company (LLC).
Limited partnership (LP).
General partnership (GP).
Contractual joint venture (JV).
Entity Choices Outside
U.S. - Business Law Aspects
1) Limitation of liability.
2) Control arrangements.
3) Profit sharing split.
4) Foreign country tax burden.
5) Foreign tax credit: (i) availability, and (ii) what (if
any) excess FTC position for U.S. owner.
Former §7701 Entity/Corp.
1) Associates (both corp. or partnership).
2) Objective to carry on business and divide the profits
(both corp or ptnship, not trust).
3) Continuity of life - death, insanity or bankruptcy not causing
dissolution of the entity.
4) Centralized management - non-owner may have continuing
authority to make management decisions for the entity (e.g., corporate
Former Code §7701
5) Free transferability of ownership interests - owners have
power, without the consent of other owners, to substitute others (not
previously equity owners) for themselves in the organization;
6) Limited Liability - no equity owner is personally liable for
the debts of or claims against the organization.
Foreign Law Criteria Applied
The factual criteria specified in (former) §7701 regulations must
be applied in determining status of an entity (including a foreign entity) as
being a corporation for U.S. tax. Foreign law determines these facts for
U.S. tax classification purposes.
Inconsistent classification is possible: Use of a hybrid
entity - a corporation for foreign law purposes but a partnership for U.S.
income tax purposes. Cf., a reverse hybrid (U.S. corp. status;
foreign flow-through entity status).
“Check-the-box” Entity -
Elective approach of structuring entities to be a (i) corporation or (ii)
partnership for U.S. tax purposes. Permits the use of “hybrid entities.”
Certain business entities are automatically classified as
corporations for U.S. tax purposes, including a list of specific foreign
entities treated as corps. for U.S. tax purposes. Reg. §301.7701-2(b)(8).
Relevant for the classification of both U.S. and foreign entities. P. 1087.
Foreign Business Entity Characterization
P. 1087. Unless the foreign entity elects
1) treated as association (and a corporation) if all
members have limited liability;
2) treated as a partnership if it has two or more members and at
least one member does not have limited liability; or
3) disregarded as an entity separate from its owner if only a
single owner that does not have limited liability.
Change in Status of the Foreign Business
Federal income tax effects:
1) Eligible entity (partnership or disregarded
entity) elects corporate status – a §351 incorporation transaction
(& §367) & a partnership distribution.
2) Eligible entity treated as a corporation elects
partnership status – treated as a corporate liquidation to the shareholders
and a contribution of these assets into a partnership.
Hybrid Entity Issues p.1089 (Corp. in
U.S. Corporate Parent
Corp Sub FCountry-1
(As a Holding Co. – Corp. for US Tax)
Operating Co. 3 (LLC?)
Finance Co. 2
interest to Finance Co. 2
(Foreign Country 3)
(Co. 2 & 3 are conduits for U.S. income tax;
no Subpart F)
Hybrid Branch & Possible
Notice 98-11 - separate status for hybrids (p.1090)?
Hybrid branch as a separate entity? Then, payments when made
are FPHC income.
Temporary Regs. - T.D. 8767, withdrawn.
Notice 98-35 - withdrawing these items
Proposed Regs. 1.954-9, pending (next slide)
Issue: Should IRS be able to promulgate a “branch rule” for
Prop. Regs. §1.954-9 (1999)
1. Hybrid payments to a related entity reducing foreign
country tax and being FPHC would be recharacterized as Subpart F
2. Hybrid status: fiscally transparent in the
US but not fiscally
transparent in the country of the payor entity.
3. “Tax disparity” test satisfied (less than
90% rate of the payor’s tax)?
Regs. still remain in proposed form in 2017.
International Tax Arbitrage
1. Double dip deal - interest deductible
in payor country but not income in payee country (since intracompany
payment). §901 credit available.
2. Subpart F is avoided. No
foreign base company income through use of the branch.
3. “Check & sell.” After tax-free
liquidation Co. sells assets and not stock and, therefore, no foreign personal
holding company income. Tax disparity test is satisfied (less than 90% rate of
payor’s tax). Dover case (on p. 552).
Proposed “Extraordinary Transaction” Rule – Former Prop. Reg. §301.7701-3(h),
where a transaction occurs in close proximity to an election to change an
entity’s tax classification. E.g., within 12 months of the election.
Note: “check and sell” transactions.
Withdrawal of this rule - Notice 2003-46.
JCT Staff Proposal
p.1097 Single Member Co.
2005 proposal: Treat as a corporation for U.S.
tax purposes the foreign entity which:
1. Is a separate business entity as organized under
foreign law; and,
2. Is a separate entity having only one
And, possible regs. to preclude the division of ownership
to avoid this corp. status rule.
The problem ultimately derives from too broad “check-the-box”
entity classification rules.
FY 2010 proposal: Treat as a corporation for
U.S. tax purposes the foreign entity which:
1. Is a separate business entity organized under
foreign law; and,
2. Is a separate entity having only one
Except where organized in the same country.
But, now Code §954(b)(6) enabling avoidance of Subpart F
treatment (as extended).
Obama proposal abandoned for FY2011 & later.
FY 2016 proposal:
Restrict use of hybrid entities used to create
“stateless income”, i.e., deduction in one
jurisdiction and no inclusion in any other foreign
Greenbook, p. 35.
Dual Resident Corporations &
U.S. corporation is permitted to file a consolidated
tax return with its affiliated corporations. §1501.
Losses of one group U.S. member can offset the
income of another U.S. group member. §1504.
Another country may treat a corporation as
resident under “management and control” test.
Dual resident corps cannot “double dip” for losses.
Code §1503(d). P.1105.
Code §904 FTC Limitation &
Planning Options p.1110
Structuring of arrangements to enable reduction of the overall
effective foreign tax rate (through low/no taxed arrangements):
1) Lending money and generating interest expense deduction
in foreign country and lower withholding rate imposed - outbound interest
2) Export of goods - pass title to (i) generate foreign
source income and (ii) avoid any income tax in the foreign jurisdiction.
Code § FTC Limitation Planning
3) Technology licensing arrangement with the foreign
subsidiary and extraction of low/no taxed, deductible royalty (income to
recipeint), to which the look-through rules are applicable for FTC.
4) Managerial and technical services in foreign country -
same planning objective, i.e., deductibility of payment for local country
income tax and low/no withholding tax at source of payment.
Capitalization of the Foreign
Use debt or special class(es) of stock?
Is the interest on the debt deductible for foreign
country income tax purposes? Cf., §163(j).
And, FTC “look-through” rule. §904(d)(3).
Debt arrangement enables the tax-free repayment of
principal (not treated as dividend but basis recovery) and is free of
the applicability of the withholding at source rules (if treaty).
Cf., stock redemption treatment under §302.
Capitalization of the Foreign
P. 1114. Transfer of intangibles as:
1. Contribution to capital (consider §§351 &
(ordinary income), or
2. Intangibles sale, lease or license (consider §482).
Consider (a) applicability of sourcing rules & (b)
tax characterization rules - ordinary income or
capital gain (e.g., sale of patent for a fixed price or
for royalty payments).
Capitalization of the Foreign
P. 1116. Transfer of tangible property (e.g.,
equipment and real property:
No gain recognized on the transfer, except for
Generate: (1) foreign source income; (2) general
limitation income (for FTC purposes).
International Joint Venture
P. 1117 What is a “joint venture” - two or
more participants with a common business objective.
Type of entity? Many choices:
- corporation (foreign or domestic), including a “special
- partnership or LLC
- contractual arrangement (no tax entity)
What requirement for a “local partner”?
International Joint Venture
"Heads of Agreement” or “Memorandum of Understanding” (MOU).
1) Organizational documents for the specific entity, e.g.,
Articles of Incorporation; Partnership agreement; by-laws and code of
regulations; organizational meeting minutes.
Structuring Joint Venture, cont.
3) Shareholder/owner agreements re control of entity &
buy-sell agreement (use a “shotgun” buy-sell agreement? P. 1125)
4) Technology licensing agreements.
5) Technical assistance agreements.
6) Management contracts.
7) Employment contracts for key personnel.
Control Arrangements for the Joint
1) U.S. minority ownership situations.
Better to use a corporation because of greater participatory rights
under local business entity laws (but consider U.S. tax planning re no
2) U.S. minority but effective control.
3) U.S. participant with majority control.
4) 50-50 joint venture (deadlock?).
Veto rights over certain actions. P.1121.
Independent financial accounting required.
Required dividend distributions.
Limits on compensation payments allowable to controlling
Indirect influence through supply contracts, technology contracts,
trademarks, secured debt financing, etc.
Achieving Effective Control
Control over entity management through designation of the managing
Alternatively, control achieved through the use of a management
Query whether local business law permits such delegation of
Cf., difficulties with deadlock (50-50) situations - use a “shotgun”
buy-sell agreement. P.1125.
U.S. Tax - Organizing the Foreign Joint
Classification of the jointly owned foreign corporation as a CFC?
Beneficial to be treated as a CFC?
Consider the Code §904 foreign tax credit baskets &
look-through rules - §904(d)(3).
Note, however, the FTC changes for 10-50 corps. (look-through
rules for post 2002 income).
What negatives of CFC status? Next slide
Negatives of CFC Status
1) Foreign base company income (Subpart F income)
2) Constructive dividend treatment for investment in
U.S. property. §956.
3) §1248 – ten percent or greater shareholder
of a CFC has
dividend treatment (rather than capital gain) when selling CFC shares
(including on liquidation). But. preferring §1248 treatment (since
indirect FTC availability)?
4) §1249 – re patent sales to CFC. P.
Control of the Foreign
How determine if “control” status exists?
1) Several classes of stock.
2) Holding power to designate the managing director of the
3) What deadlock resolution arrangements exist?
4) Purpose of avoid CFC status?
Estate of Weiskopf
Was the foreign corporation a CFC for §1248 purposes
(applicable when the stock is sold)?
Creation of a U.K. company (Ininco) qualifying as an
"Overseas Trade Corporation" (OTC).
Court: Rejecting argument Romney (a U.K. Co.) held 50 percent of
voting rights of Ininco.
U.S. shareholders controlled the product.
Therefore, Ininco held to be a CFC and not a “deadlock”
company. Cf., Koehring case.
Y foreign corporation has two classes of stock: (i) 100 shares of
no par value class A stock & (ii) 100 shares of $1 par class B stock
Class B stock has a preference on dissolution and a preference for
annual dividends (but limited amounts). Class B was foreign owned.
Corporate charter for one year with 75 percent shareholder
approval required to renew the
Rev. Rul. 70-426, cont.
X, a domestic corporation, owns all the Class A stock.
X, owning 50 percent of the total combined voting power of Y, has
the power to force Y foreign corporation into liquidation.
Consequently, X has necessary power and Y corporation is a CFC.
Relevance? E.g., if a corp. liquidation & §1248.
Assuring CFC status:
a) Control over the manager’s continuation in office.
b) Management contract.
c) Right to force liquidation or terminate important
licensing agreement if deadlock situation.
Pass-through Treatment With a
If a corporation must be used, use a U.S. partnership to
hold the stock of the foreign corporation to get CFC status.
Does the foreign corporation therefore constitute a CFC? Or, will
the partnership be disregarded and the partners be treated as directly holding
a 50 percent interest--applying an aggregate, rather than an entity,
theory of partnership?
Jointly Owned Foreign
Losses and deductions will immediately flow through to the
Income will also flow-through, but also available will be direct
foreign tax credits (which would not be available to shareholders, unless 10%
or greater interest, under the deemed paid credit rules).
Same treatment if a LLC is treated as a partnership.
Selection of the Foreign Joint Venture
“Check the box” regulations enable choice of entity, but a problem
may still exist with the foreign joint venturer who does not want to elect partnership
status where all the owners have limited liability status.
1) organizational documents?
2) subsidiary to hold partnership interest?
Interposition of a 3rd Country Holding
Wholly owned foreign corporation organized under the laws of a
third country interposed between the U.S. parent company and the foreign
Third country treaty network available?
Dividends upstream to the foreign holding company will be
recharacterized under the look through rules for FTC purposes. cont.
Interposition of a Holding
If the foreign operating company is not a CFC, then the dividends
(and rents, royalties and interest) will be foreign base company income to the
intermediate holding company (but look through when these rules became
available to 10-50 corporations).
Use foreign holding company to reduce taxation on the earnings
when distributed from the foreign country operating sub.