United States: House Ways and Means reconciliation legislation targets various tax planning techniques

In brief

On 15 September, by a vote of 24-19, the House Ways and Means Committee reported its reconciliation legislation to the House Budget Committee. The vote was a near party-line vote with Rep. Stephanie Murphy (D-FL) and the 18 Republican Committee members voting against the package. The reconciliation recommendations include a number of tax provisions that may adversely impact tax planning techniques, some of which are standard tax planning and have been utilized for many years.

Granite Trust planning

Generally, when a parent corporation liquidates a subsidiary corporation, the tax-free parent-subsidiary liquidation rules apply (Code Sections 332 and 337) so that no gain or loss is recognized by the parent or the subsidiary. If, however, the parent wants to recognize a loss on the liquidation of its subsidiary, it may reduce its ownership in the subsidiary to below 80% by selling a sufficient percentage of the subsidiary’s stock (maybe to a related partnership or foreign corporation). Doing so turns off the tax-free parent-subsidiary liquidation rules and enables the distributee corporation to recognize a loss on the liquidation of the liquidating corporation (section 331). This type of planning is referred to as “Granite Trust” planning, named after the 1956 First Circuit case, which permitted a parent corporation to recognize a loss on the liquidation of its subsidiary after it transferred part of its stock ownership (20.5%) of the subsidiary thereby reducing its ownership to 79.5%. 

The Ways and Means Committee reconciliation legislation includes a provision that appears to target Granite Trust planning if the distributee corporation and liquidating corporation are members of the same controlled group (more than 50% of vote or value stock ownership threshold) (Sec. 138142). Under the provision, a loss of the distributee corporation in a taxable liquidation is deferred until the property received in the liquidation from the liquidating corporation is sold to an unrelated person. This provision is applicable to liquidations after the date of enactment. So, although the provision does not disallow the loss, it defers recognition of the loss to the distributee corporation from the time of liquidation until substantially all of the property received in the liquidation is disposed of to a third party.

Low-vote, high-value stock and portfolio interest

Generally, US source income received by a nonresident alien individual or foreign corporation that is not effectively connected to a US trade or business is subject to a 30% flat tax collected by withholding. If the US source income is portfolio interest, then the 30% flat tax does not apply and the interest is received free of US tax. One exception to the application of the portfolio interest rules is if the interest is paid to a “10% shareholder” of the US corporation issuing the debt obligation. A 10% shareholder is any person who owns 10% or more of the total combined voting power of all classes of stock of such corporation entitled to vote. Because the 10% shareholder definition is limited to voting rights, many investors will set up a structure where the foreign investor will make a portfolio debt loan to the US corporation and own a high percent of the equity of the US corporation but less than 10% of the voting rights of the US corporation (i.e., low-vote, high-value stock). The result is that the foreign investor is not a 10% shareholder and the interest on the portfolio debt loan is portfolio interest with no US tax.

The reconciliation legislation includes a provision that appears to target cross-border tax planning utilizing the portfolio interest rules (Sec. 138145). This planning has probably been in effect since 1984, when the portfolio interest rules were enacted. The provision states that a 10% shareholder includes any person who owns 10% or more of the vote of the corporation as well as any person who owns 10% or more of the value of the corporation (Section 138145). As a result, using low-vote, high-value stock will not avoid the application of the 10% shareholder exception to the portfolio interest rules if the value of the stock is 10% or more of the value of the corporation. The provision applies to obligations issued after the date of the enactment of the Act.

10-50 companies and 245A

Generally, a domestic corporation that is a US shareholder of a specified 10%-owned foreign corporation is entitled to a 100% dividends received deduction (DRD) for the foreign source portion of any dividends from the corporation (section 245A). A “specified 10% owned foreign corporation” means any foreign corporation with respect to which any domestic corporation is a United States shareholder with respect to such corporation. The 245A 100% DRD applies to a dividend paid out of certain undistributed foreign earnings of the specified 10%-owned foreign corporation. A domestic corporate shareholder that owns at least 10% but no more than 50% of a foreign corporation (a 10/50 company), the 245A 100% DRD provides planning opportunities in selling the stock of the 10/50 company. The 10/50 company, because it is not a controlled foreign corporation (CFC), may have accumulated earnings that are not subpart F income or tested income/GILTI. In the sale of a 10/50 company, the US seller may have the sale preceded by a dividend out of the foreign corporation’s E&P. The dividend may qualify for the 245A 100% DRD.

The reconciliation legislation contains a proposal that limits the section 245A 100% DRD to the foreign-source portion of a dividend received from a CFC (Sec. 138128). A dividend received from a specified 10%-owned foreign corporation that is not a CFC, such as a 10/50 company, would no longer be eligible for the section 245A 100% DRD. The proposal would apply to distributions made after the date of enactment.

Affirmative subpart F planning

Generally, a CFC can earn three categories of income for US tax purposes: subpart F income, tested income/GILTI, and a residual category of income. The income in the first two categories is taxed annually to the US shareholders of the CFC with differing US tax consequences depending on whether the income is subpart F income or tested income/GILTI. Generally, subpart F income is mobile or passive income of the CFC. Tested income/GILTI is the active business income of the CFC. Subpart F income is taxed to the US shareholders at the full US corporate tax rate of 21% with a 100% allowance of foreign tax credits (and a carryback of one year and a carryforward of 10 years for excess foreign tax credits). Tested income/GILTI is taxed to the US shareholders with an exclusion from US tax for an amount equal to a 10% return on qualified business asset investment (resulting in GILTI), a 50% deduction of the amount of GILTI, only an 80% allowance of foreign tax credits (20% haircut on GILTI foreign tax credits), and no carryback or carryforward for excess foreign tax credits.

Generally, the tested income category results in more favorable US tax consequences, but not always. In some situations, US multinationals have engaged in affirmative subpart F planning — converting tested income of the CFC into subpart F income. A standard tax planning technique is to turn off the same country exception under subpart F thereby converting tested income into subpart F income. Assume a second-tier CFC (CFC 2), incorporated in Country X, is wholly owned by first-tier CFC (CFC1), incorporated in Country Y. Second-tier CFC (CFC 2) purchases goods from another first tier CFC (CFC 3), a manufacturer incorporated in Country Z, and sells them to customers in the same country (Country X) as its place of incorporation (Country X). The income from the sale of the goods by the second-tier CFC (CFC 2) is not foreign base company sales income because of the same country exception (incorporated in Country X and sales to customers in Country X). If, however, a check-the-box election is made with regard to the second tier CFC (CFC 2) to have it treat as a disregarded entity of first tier CFC (CFC 1), incorporated in Country Y, then the same country exception no longer applies and the income from the sale of the goods to customers in Country X becomes foreign base company sales income.

The Ways and Means Committee reconciliation legislation includes a provision that targets affirmative subpart F planning (Sec. 138129). The provision limits foreign base company sales (and services) income by excluding from the definition of “related person” persons that are not residents of the United States or passthrough entities and branches in the United States. The result is that related party sales (and services) transactions between a CFC and a foreign related party without a US taxable presence generates tested income/GILTI and not subpart F income. This provision applies to taxable years beginning after 31 December 2021.

The Ways and Means Committee reconciliation legislation includes a number of provisions, in addition to the ones described above, that appear to target specific types of tax planning, including 355 transactions, grantor trusts, retirement plans, valuation discounts and many other areas of the tax laws. It will be interesting to see whether the Senate picks up any of these tax provisions in its reconciliation legislation.

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