The Internal Revenue Service issued proposed regulations on Friday, June 14th, addressing various aspects of the controlled foreign corporation (“CFC”) rules, including with respect to global intangible low-taxed income (“GILTI”) and, significantly, who is a 10% or more shareholder for inclusion purposes regarding subpart F income and GILTI income.
Among other things, the proposed regulations would change a longstanding interpretation regarding the application of the CFC rules to domestic partnerships.
Historically, if a domestic partnership (for example, a Delaware limited partnership) owned 10% or more of the vote in a foreign corporation and that partnership and other 10% or more US shareholders owned more than 50% of the vote of the foreign corporation, then the foreign corporation was a CFC to that Delaware partnership and the other 10% or more US shareholders.
As a result, the domestic partnership would include its portion of the subpart F income of the CFC on its tax returns and allocate such income to its partners, regardless of the percentage ownership of any particular partner.
The 2017 Tax Cuts and Jobs Act (the “2017 Tax Act”), among other things, greatly expanded the scope of the CFC rules. In particular, it expanded the definition of who is a 10% or more shareholder to include shareholders who own 10% or more by value and it modified the CFC constructive ownership rules to permit the attribution of stock from foreign persons to US persons (through the repeal of Section 958(b)(4) of the Code). This change resulted in many foreign corporations being CFCs that otherwise would not have been CFCs and thus in many taxpayers (including funds and investors in funds) having CFC income where there was none before. Many taxpayers have sought the reenactment of Section 958(b)(4), or that relief be provided for its repeal, as the full consequences of its repeal did not seem to be anticipated or intended.
Surprisingly, the Proposed Regulations Narrow the Scope of Subpart F (and GILTI) Inclusions
The proposed regulations address various issues relating to GILTI (Section 951A of the Code) which was enacted in the 2017 Tax Act. Basically, GILTI is intended to be a minimum tax on CFCs.
The new regulations, however, also substantially change how the CFC rules apply in the context of domestic partnerships.
The proposed regulations include changes whereby domestic partnerships are looked through for CFC purposes regarding the inclusion of income (that is, the proposed regulations take an aggregate approach as opposed to an entity approach for inclusion purposes).
The proposed regulations would not eliminate the obligations of domestic partnerships to report their ownership of CFCs, but would fundamentally change how CFC income is taxed in the case of a CFC owned by a domestic partnership.
Example. Assume domestic fund A owns 100% of the shares in foreign corporation B. Assume A has 100 partners who are all US persons and who each own 1% of A. Assume B’s subpart F income is $1 million. Under the new regulations, B is still a CFC to A so A has reporting requirements under the CFC rules (i.e., IRS Form 5471). However, none of the partners in A have any inclusion in income under the CFC rules. It appears, however, that they could have income inclusion or other issues under the passive foreign income company (“PFIC”) rules if B is a PFIC, and it is not clear how a qualified electing fund (“QEF”) election would be made in this fact pattern, although it appears that it might still be made at the partnership level. It also appears that Section 1248 of the Code could still be an issue for A and its partners.
Income inclusion under the PFIC rules, if applicable, might be beneficial since such income could be long-term capital gain depending on the character of the underlying income included in the earnings and profits of the foreign corporation.
Many other issues may arise as we delve into the proposed regulations and how they interplay with other sections of the Code.
Effective Date of the Proposed Regulations
Domestic partnerships may, but are not required to, apply the proposed regulations to taxable years beginning after December 31, 2017, so calendar year domestic funds may apply the proposed regulations retroactively to 2018. If a domestic partnership chooses to apply the proposed regulations to 2018, the domestic partnership must apply the new rules to all the CFCs in which the domestic partnership is a 10% or more shareholder and cannot apply the new rules with respect to some but not all of such corporations.
Opportunities for Funds – Potentially Issue Amended 2018 K-1s
Many domestic funds were negatively impacted by the CFC changes enacted in the 2017 Tax Act and many of these domestic funds have already issued final 2018 k-1s to fund investors earlier this year. Fund managers should consider whether the proposed regulations would materially affect the k-1s issued to investors and whether they should provide amended k-1s to investors. There could be less income under the subpart F rules and the GILTI rules and the income may have a different character. Many investors may have filed extensions for 2018 and may not have filed their 2018 personal tax returns. For investors that have filed their 2018 personal tax returns, they will need to consider whether they should file amended tax returns if they are issued amended 2018 k-1s.
Since it may take some time for funds to evaluate whether to issue amended 2018 k-1s and since additional guidance on other issues may be issued which may also affect 2018 taxes, it might be beneficial for a fund to inform investors that it may issue amended 2018 k-1s and to hold off on filing personal tax returns if they have not already done so, until (and if) the fund issues amended 2018 k-1s.