On January 25, 2022, the Internal Revenue Service issued final regulations relating to the treatment of stock owned by domestic partnerships under certain provisions of subpart F of the Internal Revenue Code (“Subpart F”).[1] These regulations could substantially impact the tax treatment of partners of such partnerships.
Background on Foreign Corporations and the U.S. International Tax System
U.S. citizens, resident aliens, and domestic corporations generally are subject to federal income tax on worldwide income.[2]
On the other hand, foreign corporations typically are subject to federal income tax only on income 1) that is effectively connected with the conduct of a U.S. trade or business and 2) certain types of U.S. source income.[3]
However, that there are other types of income earned by a foreign corporation (i.e., foreign source income that is not effectively connected with the conduct of a U.S. trade or business) that generally are not subject to federal income tax. Taken in isolation, this results in an incentive for a U.S. person to set up a foreign corporation to receive such income, thereby “deferring” federal income tax on this income until the foreign corporation makes a distribution to the U.S. person or the U.S. person sells their shares in the foreign corporation.[4]
Background on Subpart F
Subpart F changes this result in some limited contexts. Enacted in 1962 in part due to concerns regarding deferral’s potential for abuse, Subpart F causes a U.S. shareholder of a controlled foreign corporation (“CFC”) to include as income the U.S. shareholder’s pro rata share of certain types of income earned by and certain types of investments in U.S. property made by the CFC during the taxable year (the “Subpart F inclusion”).[5]
A CFC is a foreign corporation in which U.S. shareholders hold more than 50% of 1) the total combined voting power of all classes of its stock or 2) the total value of its stock.[6] A U.S. shareholder is a U.S. person who owns at least 10% of 1) the total combined voting power of all classes of a foreign corporation’s stock or 2) the total value of the foreign corporation’s stock.[7] A U.S. person includes a U.S. citizen, resident alien, a domestic partnership, a domestic corporation, an estate that is not a foreign estate, and a trust subject to a U.S. court’s primary supervision and substantially controlled by U.S. persons.[8]
A U.S. shareholder’s Subpart F inclusion is determined by looking at the stock that the U.S. shareholder holds directly or indirectly in the CFC.[9] Whether a U.S. person is a U.S. shareholder and whether a foreign corporation is a CFC, however, is determined through the application of constructive ownership rules, which attribute ownership of stock between certain related parties.[10]
How Were Domestic Partnerships Treated Before the Final Regulations?
The federal income tax treats a partnership sometimes as an entity separate from its partners (the “entity approach”) and sometimes as an aggregate of its partners (the “aggregate approach”) depending on context.[11] Under the entity approach, the partnership—and not its partners—is treated as owning partnership assets and conducting partnership operations.[12] Under the aggregate approach, the partners of the partnership—and not the partnership—are treated as owning partnership assets and conducting partnership operations.[13]
As far as incidence of tax goes, the federal income tax generally takes the aggregate approach. A partnership is not subject to federal income tax.[14] Instead, its partners are liable for federal income tax in their separate and individual capacities on their distributive shares of partnership income and loss.[15]
Historically, however, Subpart F used the entity approach for domestic partnerships and the aggregate approach for foreign partnerships for purposes of determining the amount of a U.S. shareholder’s Subpart F inclusion.[16] In other words, a domestic partnership generally was treated as a person separate from its partners for purposes of determining the amount of the domestic partnership’s Subpart F inclusion.[17] If the domestic partnership was a U.S. shareholder with a Subpart F inclusion, then its partners each had to include as income their distributive share of the partnership’s subpart F inclusion, even if the partner was not itself a U.S. shareholder.[18] On the other hand, the partners of a foreign partnership were treated as owning the stock in a foreign corporation that the foreign partnership owned for purposes of determining the amount of the partner’s Subpart F inclusion.[19]
The enactment of the Tax Cuts and Jobs Act (“TCJA”) in 2017, and specifically its imposition of tax on a U.S. shareholder’s global intangible low-taxed income (“GILTI”), has caused the IRS to rethink its historical application of the entity approach to domestic partnerships under Subpart F.[20] Put very simply, GILTI is defined as the excess of certain net income earned by all CFCs with respect to which a person is a U.S. shareholder over a 10-percent return on tangible investment during the year.[21]
After first proposing a hybrid approach to domestic partnerships for purposes of calculating GILTI, the IRS eventually settled on an aggregate approach.[22] In this context, the IRS deemed an aggregate approach to be “necessary to ensure that . . . a single GILTI inclusion amount is determined for each taxpayer based on its economic interests in all of its CFCs.”[23] However, the IRS feared that treating a domestic partnership as an aggregate for purposes of determining a U.S. shareholder’s GILTI but as an entity for purposes of determining a U.S. shareholder’s Subpart F inclusion would be “inconsistent with legislative intent” and “introduce substantial complexity and uncertainty . . . .”[24]
Which brings us to the final regulations for domestic partnerships under Subpart F.
What Do the Final Regulations Do?
Under the newly issued final regulations, a domestic partnership will not be treated as owning stock in a foreign corporation for purposes of determining a U.S. shareholder’s Subpart F inclusion as well as for purposes of any provision that applies by reference to section 951, 951A, and 956(a) of the Internal Revenue Code.[25] Instead, stock owned by a domestic partnership will be treated as owned proportionately by its partners for these purposes.[26]
The final regulations expressly do not apply when determining whether a U.S. person is a U.S. shareholder, whether a foreign corporation is a CFC, whether a CFC has made an investment in U.S. property or is a pledgor or guarantor of an obligation of a U.S. person, whether Section 1248 of the Internal Revenue Code applies, or whether a U.S. shareholder is a controlling domestic shareholder (as defined in 26 C.F.R. § 1.964-1(c)(5)).[27] Note that constructive ownership rules would still apply in making at least some of these determinations.[28]
The Takeaway
In the short term, at least, the final regulations likely will increase complexity for partners of domestic partnership that own interests in CFCs. But there may be a silver lining. The examples included in the final regulations indicate that partners of a domestic partnership will no longer have a Subpart F inclusion merely because the domestic partnership is a U.S. shareholder of a CFC.[29] Instead, the partners must themselves be U.S. shareholders to have a Subpart F inclusion.[30]
It may take a while to process how these final regulations may impact taxpayers. If you have any questions or concerns about how they may affect you, do not hesitate to reach out to our firm for a free consultation.
International and Offshore Tax Compliance Attorneys
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[1] 87 Fed. Reg. 3648 (Jan. 25, 2022) (hereinafter, “Final Regulations”).
[2] See 26 C.F.R. §§ 1.1-1(b), 1.11-1(a).
[3] See 26 U.S.C. §§ 881, 882; Treas. Reg. § 1.11-1(a), (f). Foreign corporations with income that is effectively connected with the conduct of a U.S. trade or business also may be subject to branch profits tax. See 26 U.S.C. § 884.
[4] See Office of Tax Policy, Dep’t of the Treas., The Deferral of Income Earned Through U.S. Controlled Foreign Corporations: A Policy Study, at ix (2000) (hereinafter, “Tax Policy Study”).
[5] See 26 U.S.C. §§ 951(a), 951A(a), 956(a); Tax Policy Study, at vii, 12-14.
[6] 26 U.S.C. § 957(a).
[7] Id. § 951(b).
[8] Id. § 7701(a)(30).
[9] Id. § 958(a).
[10] Id. §§ 318(a), 958(b).
[11] See 26 C.F.R. § 1.701-2(e) (Unless a specific provision of the Internal Revenue Code prescribes or clearly contemplates treatment of a partnership as an entity, “[t]he Commissioner can treat a partnership as an aggregate of its partners in whole or in part as appropriate to carry out the purpose of any provision of the Internal Revenue Code or the regulations promulgated thereunder.”).
[12] 84 Fed. Reg. 29114, 29115 (June 21, 2019) (hereinafter “Proposed Regulations”).
[13] Id.
[14] 26 U.S.C. § 701.
[15] See id. §§ 701, 702(a).
[16] Proposed Regulations at 29116.
[17] Id.
[18] Id. (citing 26 U.S.C. § 702, which defines a partner’s distributive share of partnership income).
[19] Id. at 29116 (citing 26 U.S.C. § 958(a)(2)).
[20] Id. at 29116-18.
[21] See 26 U.S.C. § 951A. GILTI can be understood as an attempt to prevent domestic corporations from shifting income to affiliates in low-income jurisdictions that could then be distributed back to the domestic corporation free from U.S. tax under section 245A of the Internal Revenue Code (also enacted as part of the TCJA). Proposed Regulations at 29116.
[22] Id. at 29116-17.
[23] Id. at 29117.
[24] Id. at 29118-19.
[25] See Final Regulations at 3654-55 (adding new 26 C.F.R. § 1.958(d)(1)).
[26] See id. (applying the same rules to stock owned by domestic partnerships as apply to stock owned by foreign partnerships); 26 U.S.C. § 958(a)(2) (stating that stock owned by a foreign partnership is treated as being owned proportionately by its partners).
[27] Final Regulations at 3655 (adding new 26 C.F.R. § 1.958(d)(2)). Apparently, the IRS believes that at least some of these statutory provisions—specifically, the determination of whether a foreign corporation is a CFC or a U.S. person is a U.S. shareholder—require the application of the entity approach to domestic partnerships because they are keyed to the definition of a U.S. person, which includes domestic partnerships. See Proposed Regulations at 29119.
[28] See 26 U.S.C. §§ 318(a), 958(b).
[29] See Final Regulations at 3655 (adding 26 C.F.R. § 1.958-1(d)(3)(i)(B)(2)); Proposed Regulations at 29116.
[30] Final Regulations at 3655.
