Practitioners discussed the use of “blockers” for tax planning purposes at a recent meeting of the International Tax Institute in New York. Blockers are entities that are placed in a structure in order to change the character of the underlying income or assets to obtain tax results that may otherwise be unavailable. This article describes a number of strategies highlighted at the meeting and explains the types of entities and structures used.
Background on blockers. The use of blockers is quite widespread. For example, many hedge funds use foreign corporations as blockers for their investors to invest in the fund or so that the fund may invest in portfolio companies. Blockers have also been used to prevent U.S. tax-exempt organizations from recognizing unrelated business taxable income (UBTI) and to prevent foreign investors from recognizing income that it effectively connected to a U.S. trade or business.
Use of partnership with controlled foreign corporations (CFCs). Willard B. Taylor of Sullivan Cromwell LLP, considered the use of a U.S. partnership to elect into the CFC foreign tax credit rules or out of the passive foreign investment company (PFIC) rules. As an example, he considered the acquisition of a foreign corporation that would be a PFIC to U.S. investors (mostly with less than 10% interests).
Under Code Sec. 957, a CFC is defined as a foreign corporation with regard to which more than 50% of the total combined voting power of all classes of stock entitled to vote or the total value of the stock of the corporation is owned (directly, indirectly, or constructively) by U.S. shareholders. A U.S. shareholder for CFC purposes is defined as a U.S. person who owns (directly, indirectly, or constructively) 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation. (Code Sec. 951(b))
Under Code Sec. 1298(b)(1) a foreign corporation is treated as a PFIC with respect to a U.S. shareholder, and the U.S. shareholder is subject to the excess distribution regime, if the foreign corporation qualified as a PFIC, but not a Qualified Electing Fund (QEF), at any point during the U.S. shareholder's holding period. However, Code Sec. 1297(d)(1) provides that a corporation will not be treated with respect to a shareholder as a PFIC during the “qualified portion” of such shareholder's holding period with respect to the stock in such corporation. (the “overlap rule”). A qualified portion is defined as the portion of a shareholder's holding period which is after Dec. 31,’97, and during which the shareholder is a U.S. shareholder of the corporation and the corporation is a CFC. (Code Sec. 1297(d)(2))
Although the foreign corporation acquired by a partnership would normally be a PFIC, Taylor noted that some investors prefer the subpart F regime over the PFIC rules. By using a blocker, if the investors invest in the foreign corporation through a U.S. partnership, they may opt out of the PFIC rules under Code Sec. 1297(d)’s “overlap” rule (see, e.g., PLR 201107004).
“You could look at this and say if Congress in the time they enacted the overlap rule was presented with a statute that said that you could have been a PFIC or a CFC at your election, would they have passed it?” he asked. “I'm not so sure.”
Investment in commodities through regulated investment companies (RICs). Under Code Sec. 851(b)(2), to be a RIC for a tax year, a corporation must meet an income test (qualifying income requirement) under which at least 90% of its gross income is derived from certain enumerated sources, including dividends, interest, payments with respect to securities loans, and gains from the sale or other disposition of stock or securities or foreign currencies, or other income (including but not limited to gains from options, futures or forward contracts) derived with respect to the RIC's business of investing in the stock, securities, or currencies. Commodities such as precious metals, however, are not included in Code Sec. 851(b)(2).
To get around this, a RIC may organize a foreign subsidiary that invests in commodities. Income (including dividend and subpart F) from the RIC's investment in the foreign corporation complies with the requirements of Code Sec. 851(b)(2). In effect, by using the foreign subsidiary as a “blocker,” the underlying commodity assets have been converted to RIC qualifying income.
The subsidiary may invest in commodities without paying U.S. tax. Moreover, if the subsidiary is located in tax haven jurisdictions such as the Cayman Islands, investment in commodities may be tax-free.
Publicly-traded partnerships (PTPs). John Hart of Simpson, Thacher & Bartlett LLP outlined a similar strategy using PTPs.
A PTP is taxable as a corporation under Code Sec. 7704(a). A partnership is a PTP if interests in the partnership either: (1) are traded on an established securities market (including a national exchange, a regional or local exchange, certain foreign exchanges, and an interdealer quotation system), or (2) are readily tradable on a secondary market or its substantial equivalent. (Code Sec. 7704(b)) However, a PTP won't be treated as a corporation if at least 90% of its gross income for the tax year is specified passive-type income, and certain other requirements are met. (Code Sec. 7704(c))
To get around the 90% limitation, the PTP can set up a subsidiary corporation which would then engage in earning the non-qualifying income. The subsidiary could be a U.S. or foreign corporation.
In the hands of the partnership, the income may take the form of dividends, gain on sale of the subsidiary's stock, subpart F income (if a foreign subsidiary), or PFIC inclusion, etc. Thus, through the use of a taxable corporation, the underlying non-qualifying income is converted to qualifying income.
Hart said that some taxpayers had taken the strategy one step further and placed debt in the subsidiary corporation. The subsidiary then made interest payments to the PTP, which was then considered qualifying income in the hands of the PTP. The subsidiary, in turn, was entitled to a deduction, thereby reducing the group's tax burden.
Elimination of UBTI through the use of a foreign corporation. Hart also outlined a strategy for tax-exempt investors seeking to invest in a U.S. partnership that either makes leveraged investments or investments that generate income not excluded from UBTI.
UBTI generally includes an organization's gross income from any unrelated trade or business, defined in Code Sec. 513, regularly carried on by it, less allowable deductions that are directly connected with the activity. (Code Sec. 512(a); Reg. §1.512(a)-1)
If the tax-exempt investor engaged in the investment directly and the activity was an active business, it might be viewed as UBTI. However, if the activity were instead conducted in a blocker foreign corporation, the foreign corporation would not be subject to U.S. tax (because its not a U.S. activity) and the non-U.S. owner would get income from the foreign corporation in the form of dividends or gain on the sale of shares of the foreign corporation. Assuming that the tax-exempt entity does not borrow money to make an investment in the foreign corporation, that type of income would not be UBTI.
Use of foreign corporation to shield foreign investors from filing U.S. tax return. Hart also presented an option for foreign investors seeking to invest in a U.S. partnership with business income that was effectively connected with a U.S. business but who did not want to file a U.S. tax return.
Rather than engaging in the activity directly, the foreign investors could establish a foreign corporation, and the foreign corporation could engage in the activity and earn the income effectively connected with the U.S. business. However, the effectively connected income is still subject to tax in the foreign corporation's hands (and possibly the branch profits tax), and the foreign investors may not achieve any tax savings on the use of the structure. In some circumstances, the investors could actually pay more U.S. tax, because if they are natural persons, they would not be subject to the branch profits tax; and capital gains could also potentially be imposed at higher rates through the use of a foreign corporation vis-a-vis foreign individuals. However, the foreign investors would be shielded from having to file a U.S. tax return.
Use of a partnership to allow nonresident aliens (NRAs) to invest in an S corporation. Under Code Sec. 1361 1, in order for a corporation to elect to be an S Corporation: (1) it must be a domestic corporation (or an entity classified as an association taxable as a corporation) that isn't an ineligible corporation; (2) it must have no more than 100 shareholders; (3) each shareholder must be an individual, a decedent's estate, a bankrupt's estate, or a specified type of trust or exempt organization, and no shareholder may be a NRA; and (4) it can have only one class of stock.
To get around the limitation on NRAs, an S corporation can form a partnership where it and the NRAs are partners. This results in substantively the same economic and legal rights as though the NRAs were direct shareholders in the S corporation.
Foreign investment in real estate investment trusts (REITs) through a structure that avoids tax due under the Foreign Investment in Real Property Tax Act (FIRPTA). Taylor described a structure that would allow a foreign corporation with investments in U.S. real estate to effectively elect out of FIRPTA.
FIRPTA added Code Sec. 897, Code Sec. 1445, and Code Sec. 6039C to the Code, which respectively impose income tax, withholding tax, and information reporting requirements on NRAs and foreign corporations that dispose of U.S. real property interests (USRPIs).
A gain or loss of a NRA or foreign corporation from the disposition of a USRPI is treated as effectively connected with a U.S. trade or business. (Code Sec. 897(a)(1) Under Code Sec. 897(c), a USRPI includes: (1) an interest in real property located in the U.S. or the Virgin Islands, and (2) any interest (other than solely as a creditor) in any U.S. corporation unless it's shown not to have been a U.S. real property holding corporation during the five-year period ending on the date of disposition.
However, an interest in a REIT isn't treated as a USRPI if the REIT is a domestically controlled qualified investment entity (QIE) under Code Sec. 897(h)(2), which in turn must meet certain requirements with regard to its U.S. real property holdings. (Code Sec. 897(h)(4)) A QIE is domestically controlled if at all times during the relevant testing period less than 50% in value of the stock was held directly or indirectly by foreign persons. (Code Sec. 897(h)(4))
Under the strategy, a REIT could be established for each U.S. property held by the foreign corporation. The foreign corporation would technically own less than 50% of the value of each REIT, and the balance could be owned by a U.S. subsidiary of the foreign corporation or by a U.S. investor that agrees to hold its investment in the REIT for at least five years.
Taylor said that the foreign corporation could essentially elect out of FIRPTA on real estate gains under the “domestically controlled” REIT rule under Code Sec. 897(h)(2) (see PLR 200923001, which provided that where a domestic corporation is the actual owner of stock in a REIT, foreign ownership of the corporation is disregarded).
References: For passive foreign investment companies, see FTC 2d/FIN ¶O-2202; United States Tax Reporter ¶12974; TG ¶30305. For RICs, see FTC 2d/FIN ¶E-6001; United States Tax Reporter ¶12974; TG ¶20525.