The Myth of Downward Attribution

by John Anthony Castro, J.D., LL.M.

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UPDATE

On October 1, 2019, the IRS announced it had released Revenue Procedure 2019-40, which outlined the safe harbor rules for "preventing" downward attribution.  Simultaneously, the IRS announced Proposed Regulations regarding ownership attribution for CFC determination purposes.

In summary, the IRS realized the law was against them, so they promulgated regulations purporting to prevent downward attribution even though they did not have the legal authority to even enforce downward attribution if they wanted. Our law firm was the only firm in the entire U.S. to take a stand for taxpayers and, once again, we have prevailed. 

Stop working with firms that act less like advocates and more like IRS employees. You deserve tax counsel that will diligently advocate on your behalf. Contact our firm today to schedule a free consultation.

Background

I. Controlled Foreign Corporations

As a general rule, foreign corporations are not subject to the United States tax on their foreign source income. However, under Subpart F, United States shareholders of a controlled foreign corporation are required to include as a constructive dividend from the controlled foreign corporation their pro rata portions of its earnings and profits or its increase in direct or indirect investments in United States property.

Not every foreign corporation, or even every foreign corporation owned in part or all by United States persons, is a controlled foreign corporation. Treasury’s “check-the-box” regulations have virtually eliminated questions as to whether a foreign entity is a “corporation” for United States tax purposes. Under the “check-the-box” regulations, shareholders are generally allowed to elect how an entity will be treated for United States tax purposes. Regulations provide a list of foreign entities that are automatically treated as corporations for United States tax purposes. Such corporations are referred to as per se corporations. Shareholders of a per se corporation may not elect to treat such entity as anything other than a corporation.[1] If an entity is not a per se corporation (an “eligible foreign entity”) the owners may elect to have such entity treated as a corporation, or depending on the number of shareholders elect to treat the entity as a partnership or have the entity’s separate legal existence disregarded from that of the owner. An eligible foreign entity with two or more members may elect to either be treated as a corporation or a partnership. An eligible entity with a single owner may elect to be treated as corporation or disregarded as an entity separate from its owner.[2]

Generally, unless an eligible foreign entity elects otherwise, foreign eligible entities will be treated as follows:

  • as a partnership if it has two or more members and at least one member does not have limited liability;[3]
  • as a corporation if all members have limited liability; and [4]
  • as disregarded as an entity separate from its owner if it has a single owner that does not have limited liability.[5]

Not every foreign entity classified as foreign corporation will be treated as a controlled foreign corporation. The Code defines a controlled foreign corporation as any foreign corporation if:[6]

  • more than 50% of the total voting power of all classes of stock that are entitled to vote is owned by United States shareholders on any day during the taxable year of the foreign corporation; or
  • more than 50% of the total value of stock of the corporation is owned[7] by United States shareholders on any day during the taxable year of the foreign corporation.

The term “United States shareholders” is defined in Section 951(b) to include only United States persons owning or considered as owning 10% or more of the outstanding voting stock. The constructive rules of ownership provided in Section 958 apply.

Generally, United States persons owning merely a portfolio interest in a foreign corporation will not impact whether the entity is a controlled foreign corporation. As discussed, only United States persons owning 10% or more of the outstanding voting stock is counted in determining whether a foreign corporation constitutes a controlled foreign corporation. For example, if eleven United States persons each owned 9% of the total voting stock of foreign corporation X, foreign corporation X would not constitute a controlled foreign corporation. None of X corporation’s shareholders would constitute “United States Shareholders.” Obviously foreign corporations that are wholly owned subsidiaries of domestic corporations are controlled foreign corporations. Controlled foreign corporation status may also be created in a variety of other ownership combinations by “United States shareholders.” For example, if five U.S. persons each own more than 10% of a foreign corporation voting stock, the entity will constitute a controlled foreign corporation.[8]

a. United States Shareholder

Subpart F requires the inclusion in gross income of a United States shareholder of his pro rata shares of controlled foreign corporation’s Subpart F income, previously excluded Subpart F income withdrawn from investment in less developed countries, previously excluded Subpart F income withdrawn from foreign base company shipping operations, and increase in earnings invested in United States property, for its taxable year.[9] The United States shareholder, with respect to any foreign corporation, represents the following:[10]

  • a United States person;
  • who owns directly or indirectly, or constructively; and
  • ten percent or more of the total combined voting power of all classes of voting stock in the foreign corporation.

i. United States Person

Basically, a United States person is that natural or legal person that is a citizen or resident of the United States, a domestic partnership or corporation, or an estate or trust other than a foreign estate or trust that has excludible foreign source income.[11] The United States person excludes individuals who are bona fide residents of Puerto Rico and whose dividends received from corporations organized under the laws of Puerto Rico, essentially, would be treated as income derived from sources within that possession.[12] Corporations organized under the laws of Guam, American Samoa, and the Northern Marianna Islands are also excluded from the definition of United States person for purposes of Subpart F if the such corporation meets the following requirements:

  • Eighty percent or more of the gross income of which for the three-year period ending at the close of the taxable year was derived from sources within such possession or was effectively connected with the conduct of a trade or business in such possession; and
  • fifty percent or more of the gross income of which for such period was derived from the active conduct of a trade or business in such possession.[13]

Individuals that are bona fide residents of Guam, American Samoa, or the Northern Mariana Islands are also excluded from the definition of United States person for purposes of Subpart F.[14]

ii. Ownership of 10% or More

The determination of whether a United States person owns the requisite 10% of voting power of all classes of stock entitled to vote is made based on the facts and circumstances of each case.[15] However, in all cases where a United States person owns 20% or more of the total number of shares of a class of stock of a foreign corporation, which class of stock possesses one or more of the powers of disposition of the majority of the board of directors or its foreign counterpart, determination of the board’s deadlock and disposition of a corporate president serving in lieu of a board of directors,[16] the United States person will be deemed to own 10% or more of the total combined voting power of the voting stock in the foreign corporation.[17]

The United States person’s ownership of the foreign corporation’s stock includes stock owned directly by the United States person herself, and stock owned directly or indirectly by foreign corporations, foreign partnerships, or foreign trusts or estates, as attributed pro rata to such foreign entity’s shareholders, partners or beneficiaries.[18] It further includes the foreign corporation’s stock that the United States person constructively owns, as determined under the attribution rules of Section 318(a), subject to particular modifications.[19]

1. Direct Ownership

Subpart F treats one as owning the stock that one owns directly in a foreign corporation.[20] The authorities do not elaborate on the meaning of direct ownership.[21] One might presume that direct ownership corresponds to legal title or equitable interest under local law, with such ownership that is less than direct ownership, but which remains other than constructive ownership and yet is cognizable under the facts and circumstances as some species of ownership, to be designated as indirect ownership. This view seems mistaken, however, inasmuch as Subpart F defines indirect ownership very particularly as well.[22] Nonetheless, the general principle of substance over form plainly applies under Subpart F.[23] Therefore, an observance of substance over form might be charged to direct ownership of stock. For example, the transfer of nominal control of a CFC will be disregarded if voting power is retained by the transferor under an informal voting arrangement.[24]

The Service has distinguished direct and indirect ownership in the following example.[25] P, a domestic corporation, founded its wholly owned, foreign subsidiaries FS1 and FS2 in 1964. Both were controlled foreign corporations with earnings and profits. In 1980, P transferred all of the stock of FS2 to FS1, as a contribution to capital and not part of a reorganization. Then, in 1982, P sold all of the stock of FS1.

On the effective sale of the stock of FS2, the question arose whether ordinary income treatment to P under Section 1248(a) would apply to all amounts of earnings and profits of FS2, from 1964 through 1982, or whether such treatment would apply only to the earnings and profits of FS2 following the contribution of its stock FS1, from 1980 through 1982.

The issue depended upon interpretation of Section 1248(c)(2)(D)(ii), which imposes the literal requirement that the domestic shareholder have owned the stock of the foreign subsidiary only indirectly, within the meaning of Section 958(a)(2). The Service ruled that Section 1248 applies to all of the earnings and profits of FS2 notwithstanding that P had directly rather than indirectly owned the stock of FS2 from 1964 through 1980. Only this nature of P’s ownership interest had changed, and the Service dismissed the distinction of direct and indirect ownership as having “no relevance” to the Congressional purpose in Section 1248.

2. Indirect Ownership

Under the indirect ownership provisions of Section 958(a), stock owned, directly or indirectly, by or for a foreign corporation, a foreign partnership, or a foreign trust or foreign estate, in considered as owned proportionately among such foreign entity’s shareholders, partners, or beneficiaries.[26] The significant effect of indirect ownership is that a foreign corporation directly or indirectly owning stock in a foreign corporation is treated as actually owning the stock, for purposes of the continuous application of indirect ownership toward the creation of a chain of ownership by foreign entities.[27]

a. Proportionate Interest

The determination of the proportionate ownership or interest of a United States person in a foreign corporation, foreign partnership, foreign trust, or foreign estate or of a foreign corporation, partnership, or trust or estate itself for purposes of the chain-of-ownership rule, depends upon the facts and the circumstances of the case. This rule is true as well for the determination of the proportionate interest of a foreign corporation, partnership or trust or estate in such another foreign entity, for purposes of the chain-of-ownership rule.[28]

The Regulations state, where the United States shareholder’s ownership of stock is to be known for the computation of his pro rata share, that all person’s proportionate interest in foreign corporations are to be determined in light of the particular person’s interest in the income of the particular foreign corporation.[29] Where indirect ownership is significant to the identification of voting power, for purposes of the definition of the United States shareholder or the controlled foreign corporation, the person’s proportionate interest in the foreign corporation is to be determined with reference to the amount of voting power held by the particular person in the particular corporation. The Regulations also expressly disregard any arrangement of ownership or interest that “artificially decreases” the proportionate interest of a United States person.[30]

b. Chain of Stock Ownership

Where stock is owned directly or indirectly, and by or for, a foreign entity, or is deemed to be owned proportionately by a foreign entity’s shareholders, partners, or beneficiaries, the stock is considered to be owned actually by such persons, for the purposes of the continuous application of the indirect ownership rules.[31] Where a foreign entity owns stock, a chain of ownership is created throughout its shareholders, partners or beneficiaries, as the case may be, and then through their respective shareholders, partners, or beneficiaries. However, because this rule concerns only the attribution of ownership to foreign entities, attribution under the provision stops with the first United States person in the chain of ownership running from the foreign entity.[32]

3. Constructive Ownership

Constructive ownership of stock, under Section 958(b), also is significant to the definitions of the United States shareholder and the controlled foreign corporation as well as to the United States person, related persons, and United States property, under Subpart F.[33] Section 958 incorporates the attribution rules under Section 318(a), to the extent that the effect is to treat any United States person as a United States shareholder, to treat a person as a related person in the context of foreign base company sales income, to treat the stock of a domestic corporation as owned by a United States shareholder of the controlled foreign corporation for the definition of United States property, or to treat a foreign corporation as a controlled foreign corporation.[34]

a. Option Attribution

The Regulations also repeat the rule under Section 318(a) on attribution from options. Where there exist an option to acquire stock, or a series of options on option on stock, the stock is attributed to the option holder.[35] Where both family attribution and option attribution would apply, the option attribution rules control.[36]

b. Exceptions

Section 958(b) further provides for exceptions to its incorporation of Section 318(a). These concern the rules for attribution between members of the family, attribution from partnerships, estates, trusts and corporations, attribution from corporations in a separate regard, and attribution to partnerships, estates, trusts and corporations.

i. Prohibition of Foreign Family Attribution

Under Section 318(a), an individual is considered to own the stock owned directly or indirectly, by or for his spouse, his natural or legally adopted children, his grandchildren and his parents.[37] Under this first exception, stock owned by a nonresident alien individual, other than a foreign trust or foreign estate, is not to be attributed to a citizen or to an individual who is a resident alien.[38] However, this exception does not apply for purposes of determining whether the stock of a domestic corporation is owned or considered as owned by a United States shareholder under section 956(b)(2) and § 1.956-2(b)(1)(viii).[39]

ii. Reduction for Corporate Look-Through

Section 318(a) generally provides for the attribution of stock owned, directly or indirectly, by partnerships, estates and trusts proportionally among their respective partners, legatees and beneficiaries.[40] This proportional attribution applies also from corporations. But under Section 318 there is only attribution from a corporation to shareholders that own, directly or indirectly, 50% or more in value of the corporation’s stock. Section 958 reduces the Section 318 50% threshold for attribution from corporations to shareholders to 10%. Thus, if 10% or more in value of the stock is owned, directly or indirectly, by or for a person, there is attributed to that person the stock owned, directly or indirectly, by or for the corporation, in the proportion that the value of the corporation stock that the person owns bears to the value of all of the stock in the corporation.[41]

iii. Fifty Percent Floodgate

In conjunction with the foregoing, Section 958(b) expands the rule for attribution from partnerships, estates, trusts and corporations under Section 318(a), to provide, where a partnership, estate, trust or corporation owns, directly or indirectly, more than 50% of the total combined voting power of all classes of voting stock in a corporation, that the partnership, estate, trust or corporation is considered to own all of the corporation’s voting stock.[42]

iv. Partnerships, Estates, Trusts and Corporations

Generally, again, Section 318(a) provides for the attribution from partners, legatees, and beneficiaries to their respective partnerships, estates, and trusts.[43] The stock owned by a person may be attributed to any corporation in which he holds stock, but only where the person holds, directly or indirectly, 50% or more of the value of the stock in the corporation to which the attribution would be made.[44]

However, such attribution to partnerships, estates, trusts and corporations is not to be applied to attribute to a United States person the ownership of stock which is owned by a person that is not a United States person.[45]

v. “Bootstrap” Attribution

Section 958(b) is made to avoid “bootstrap” attribution in that stock attributed to a member of a family is not considered as owned by him for the purpose of its reattribution to another member of the family.[46] Stock attributed to partnerships, estates, trusts, and corporations, from their partners, beneficiaries, and shareholders, is not treated as owned by such entities for purposes of reattribution to other partners, beneficiaries, and shareholders.[47]

4. Other Ownership Rules

In general, though, a person to whom stock is attributed is treated as its actual owner, and each step in the analysis is to employ that particular attribution rule that will impute to the person or persons concerned the largest total percentage of stock.[48] Thus, in the determination of respective persons status as United States shareholders in a foreign corporation, stock in the foreign corporation owned by a domestic corporation may be attributed to the domestic corporation’s shareholder, for the sole purpose of determining the domestic individual shareholder’s status as a United States shareholder, without present regard to the domestic corporate shareholder. The Regulations give the following example:[49]

United States persons A and B, and domestic corporation M, own 9%, 32%, and 10%, respectively, of the one class of stock in foreign corporation R. A also owns 10% of the one class of stock in M Corporation. For purposes of determining whether A is a United States shareholder with respect to R Corporation, 10% of the 10-percent interest of M Corporation in R Corporation is considered as owned by A …. Thus, A owns 10% (9% plus 10% of 10%) of the stock in R Corporation and is a United States shareholder with respect to such corporation. Corporations M and B, by reason of owning 10% and 32%, respectively, of the stock in R Corporation are United States shareholders with respect to such corporation.

Person A is attributed ownership of 10% of R corporation’s stock. The domestic M Corporation, however, retains its nominal 10% share, for purposes of its own status as a United States shareholder in R Corporation, even though 1% of R Corporation’s shares were attributed from M Corporation to A.[50]

As the Regulations continue, such double counting cannot be performed in determination of R Corporation’s status as a controlled foreign corporation:[51]

For purposes of determining whether R Corporation is a controlled foreign corporation, the 1% of the stock in R corporation considered as owned by A and directly owned by M Corporation cannot be counted twice. Therefore, the total amount of stock in R Corporation owned by United States shareholders is 51%, determined as follows:

Stock Ownership in R Corporation

A

9%

B

32%

M Corp

10%

Total

51%

This step constitutes only a single determination under the attribution rules.

II. The Myth of Downward Attribution

The theory behind so-called “downward attribution” is that, because of the repeal of Section 958(b)(4), a foreign corporation’s direct ownership of a subsidiary is attributed to the foreign corporation’s U.S. subsidiary. As a result, this theory holds that the U.S. subsidiary is deemed to be the parent of the sister corporation, which makes the sister corporation a controlled foreign corporation. The downward attribution theorists, therefore, ludicrously conclude that an entirely foreign-owned and foreign-operated global corporate network of entities is suddenly deemed to all consist of controlled foreign corporations as a result of a single U.S. subsidiary.

This theory is not only extinguished by Section 318(a)(5)(C) but also contravenes the unambiguously expressed intent of Congress, which has been confirmed by the Internal Revenue Service’s Deputy Associate Chief Counsel for the International Division, Daniel McCall.

III. Legal Solutions Developed by Castro &Co.

Aside from the fact that Deputy Associate Chief Counsel, Daniel McCall, for the International Division of the Internal Revenue Service has publicly stated that the U.S. Treasury intends to promulgate regulations clarifying the nonexistence of downward attribution, Castro & Co. has developed a multifaceted solution to clarify the nonexistence of the threat as well as to safeguard against it for those that believe the concern warrants proactive, defensive planning. However, we cannot stress enough that there is no such thing as “downward attribution.” Nevertheless, for those that wish to be conservative, here are some of the solutions.

A. The Section 318 Operating Rules Block Downward Attribution

As previously discussed, the constructive ownership rules in Section 318 can attribute stock ownership between family members, from entities, and to entities. However, the most critical component of Section 318 is the Operating Rules under Section 318(a)(5).

The operating rules found in Section 318(a)(5) are largely designed to prevent multiple attribution whereby you could theoretically endlessly connect the dots between people and entities to make a wholly unrelated person a constructive owner of a foreign corporation. In particular, Section 318(a)(5)(C) reads:

Stock constructively owned by a… corporation by reason of the application of paragraph (3) shall not be considered as owned by it for purposes of applying paragraph (2) in order to make another the constructive owner of such stock.

The key element is that this provision covers both indirect and direct ownership, which is counterintuitive since Section 318 is presumably limited to dealing with constructive ownership. With that in mind, Section 318(a)(5)(C) is effectively communicating that stock attributed to one, whether directly or indirectly, cannot be reattributed to another. In other words, if a parent corporation has two subsidiaries, it’s ownership of one subsidiary cannot be attributed to its other subsidiary to transform the other subsidiary into the effective parent of the other subsidiary. More succinctly stated, stock of one subsidiary owned directly by a parent cannot be attributed to another subsidiary. It is improper to attribute a parent corporation’s ownership of one subsidiary to another subsidiary owned by the same parent. To do so is the functional equivalent of treating a child as the parent of his sibling. This is the nonsensical result that Section 318(a)(5)(C) prevents.[52] This is the provision that blocks the downward attribution of stock in a sister corporation by operation of law.

B. The Unambiguously Expressed Intent of Congress Blocks Downward Attribution

The United States Court of Appeals for the Federal Circuit has ruled that the Treasury is prohibited from promulgating regulations that exceed the “unambiguously expressed intent of Congress.”[53] Treasury regulations that contravene the intent of Congress are invalid as a matter of law. Being unable to promulgate new regulations contravening the intent of Congress, the original regulations will continue to limit the IRS’s authority under Section 958.[54]

As articulated in the historical legislative record, so-called “downward attribution” was only intended to apply when the parties in question were related under Section 954(d)(3). Section 954(d)(3) provides that a person is a related person if the person is an individual, corporation, partnership, trust, or estate that controls, or is controlled by, the CFC, or the person is a corporation, partnership, trust, or estate that is controlled by the same person or persons that control the CFC. For corporations, control means the ownership, directly or indirectly, of stock possessing more than 50% of the total voting power of all classes of stock entitled to vote or of the total value of stock of that corporation. In other words, the express intent of Congress was to limit the repeal of Section 958(b)(4) to situations in which the U.S. shareholder controlled or was otherwise related to the U.S. person to which “downward attribution” from a non-U.S. person applied.

Despite this unambiguous Congressional intent, the new Section 958 neither includes any reference to this control or relation requirement nor any other indication that the repeal was intended to be anything less than a full repeal of Section 958(b)(4). In fact, the amended text simply repealed the existing Section 958(b)(4) language without including any additional text or limitations on the bounds of the outright repeal.

In Senate Amendment 1666, Senator David Perdue (R-GA) proposed a clarification that would have codified the Section 954(d)(3) limitation with respect to the repeal of Section 958(b)(4). Basically, the amendment would have codified the explanatory text of the report from the Finance Committee to reflect that the repeal of Section 958(b)(4) was only intended to be a partial repeal and would still be in effect when a U.S. person is not related to the U.S. shareholder to which stock is attributed down to a foreign person. This amendment, however, was not adopted because it was not seen as necessary by Senator Orrin Hatch, then-Chairman of the U.S. Senate Finance Committee.

During floor debates in the Senate on December 19, 2017, Senator Perdue again expressed his concern that the Section 954(d)(3) limitation did not appear in the final text and that the repeal of Section 958(b)(4) should be clarified to be a partial repeal. While on the Senate floor, Senator Perdue requested confirmation that the “conference report language did not change or modify the intended scope this statement [i.e., the requirement that the U.S. person be a related person] ... [and] that the Treasury Department and the Internal Revenue Service should interpret the stock attribution rules consistent with this explanation of the bill.”[55] Senator Orrin Hatch (R-UT) responded by stating the “bill does not change or modify the intended scope of the statement [Senator Perdue] cites...[and] [t]he Treasury Department and the Internal Revenue Service should interpret the stock attribution rules consistent with this explanation.”[56] Senator Hatch also noted that the reason Senate Amendment 1666 was not adopted was because it was not needed. In other words, Senator Orrin Hatch was convinced that the stock attribution rules, as they currently exist, were capable of being interpreted in a manner that did not result in downward attribution in cases not involving related parties or abuse.

In this Senate floor exchange, Congressional intent from the leading political figures behind these amendments is unmistakable. The repeal was intended to narrow an existing rule to prevent a specific abuse. The legislative history further supports the notion that the repeal of Section 958(b)(4) was intended to apply only to U.S. persons related to the U.S. shareholder, within the meaning of Section 954(d)(3), to which downward attribution was made.

Notwithstanding the foregoing, Treasury is still legally prohibited under the Federal Circuit jurisprudence from promulgating regulations interpreting Sections 958 and 318 in a manner that exceeds Congressional intent. This means taxpayers are free to proceed on the basis that there is no downward attribution, and both Treasury and the IRS, if they wanted to challenge, would have to enter federal court with no judicial deference advantage and overcome established case law in the United States Court of Federal Claims.

C. Check-the-Box on Foreign Entities as a Safeguard Against Downward Attribution

Another consideration is check-the-box elections for foreign subsidiaries. A check-the-box election is an entity classification election that allows a foreign entity to choose its entity type. For example, the flexible election allows certain foreign corporations to operate in corporate form or to be treated as disregarded as an entity separate from its owners from a U.S. tax perspective. Due to certain limits on downward attribution of one’s own stock, targeted check-the-box elections may limit the impact of the repeal of Section 958(b)(4). Specifically, Treasury regulation 1.318-1(b)(1) provides that a corporation cannot be considered to own its own stock by virtue of the attribution rules. As a result, a parent corporation cannot be considered as owning its own stock, and by extension, none of its U.S. subsidiaries will be considered as owning its stock. By turning the subsidiary entities into branches, the foreign parent’s ownership of the formerly deemed CFCs are now all treated as one entity from a U.S. perspective, and the stock of the now single parent entity cannot be attributed down to a U.S. subsidiary. Taxpayers must evaluate scores of considerations when contemplating these elections, but, in the right circumstances, those elections could provide significant relief to affected taxpayers.

Alternatively, taxpayers may consider converting U.S. subsidiaries into branches. Instead of eliminating the entities that can be attributed down to a U.S. subsidiary (as in the check-the-box planning), the individual could eliminate the U.S. entity to which the downward attribution applies. If there are no other U.S. entities in the structure, this would prevent the CFC rules from applying. As before, each option requires significant consideration because it can result in current taxation of built-in gains and subjects the domestic operations to foreign branch tax rules.

D. Make a Section 962 Election

Another consideration for an individual U.S. shareholder concerned about owning a possible CFC as a result of downward attribution is a Section 962 Election. This election would allow the individual to subject to corporate tax rates, which would allow the individual to pay tax as a corporation. The benefit is that it would allow the individual to claim credit for foreign taxes paid by the foreign entity that would otherwise not be available. This election requires complex calculations and reporting but would limit tax exposure from the CFC.

Conclusion

If your current international tax attorney, CPA, or advisor is pushing the myth of “downward attribution” on your company, you need to contact us immediately to schedule a free consultation. Unlike other firms, we handle tax litigation. We are not unfamiliar with taking the IRS to court to prove our case. Your current advisor will likely engage in further scare tactics; convincing you that the IRS will target you. They’ll unethically say anything to prevent you from thinking for yourself and calling our firm. Don’t fall for it. We don’t bill for consultations. And all of our engagements are contingent, which means we stand behind our advice and planning and only bill if and when the IRS concedes.

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About the Author

John Anthony Castro, J.D., LL.M., is the Managing Partner of Castro & Co., the author of International Taxation in Plain English as well as International Estate Planning in Plain English, an esteemed graduate of Georgetown University Law Center in Washington DC, an OPM Fellow at Harvard Business School, and an internationally recognized tax attorney with offices in New York, Los Angeles, Miami, Chicago, Dallas, and Washington DC.

To provide feedback on this article or suggest an idea for a future article, please contact Tiffany Michelle Hunt, J.D., LL.M., Director of Tax Planning at Castro & Co., at T.Hunt@CastroAndCo.com.


Bluebook Citation: John Anthony Castro, The Myth of Downward Attribution, Castro Int’l Tax Blog (June 18, 2019).


[1] Treas. Reg. § 301.7701-2(b)(8). The Service intends to amend Reg. § 301.7701-2(b)(8) to add the Croatian dionicko drustvo to the list of entities that are per se corporations. The addition will apply to such entities formed on or after July 1, 2013, and to an entity formed before such date from the date after July 1, 2013, provided a 50% or more interest in such entity is owned by any person or persons who were not owners of the entity as of July 1, 2013. For this purpose, an interest is: in the case of a partnership, a capital or profits interest; and in the case of a corporation, an equity interest measured by vote or value. Notice 2013-44.

[2] Treas. Reg. § 301.7701-3(a).

[3] Treas. Reg. § 301.7701-3(b)(2)(A).

[4] Treas. Reg. § 301.7701-3(b)(2)(B).

[5] Treas. Reg. § 301.7701-3(b)(2)(C).

[6] IRC § 957(a).

[7] Within the meaning of IRC § 958, involving both actual and constructive ownership.

[8] See IRC §§ 951(b), 957(a); Treas. Reg. § 1.957-1(a). Whether a corporation is controlled by United States shareholders is determined by actual voting power, not a mechanical test of stock ownership. Garlock v. C.I.R., 58 T.C. 423 (1972), aff’d, 489 F.2d 197 (2d Cir. 1973). Kraus v. C.I.R., 59 T.C. 681 (1973), aff’d, 490 F.2d 898 (2d Cir. 1974).

[9] IRC § 951(a)(1).

[10] IRC § 951(b); Treas. Reg. § 1.951-1(g)(1).

[11] IRC § 7701(a)(30), (31).

[12] IRC § 957(c); Treas. Reg. § 1.957-4(a)(1).

[13] IRC § 957(c)(2)

[14] IRC § 957(c)(2)

[15] Treas. Reg. § 1.952-1(g)(2)(i).

[16] Treas. Reg. § 1.957-1(b)(1).

[17] Treas. Reg. § 1.951-1(g)(2)(i).

[18] IRC §§ 951(b), 958(a); Treas. Reg. § 1.951-1(g)(1).

[19] IRC §§ 318(a), 951(b), 958(b); Treas. Reg. § 1.951-1(g)(1). See Procter and Gamble Co. v. C.I.R., 95 T.C. 323 (1990), aff’d, 961 F.2d 1255 (6th Cir. 1992) where the Commissioner’s allocation of royalty income from a corporation’s second-tier Spanish subsidiary to a first-tier Swiss subsidiary was not warranted where Spanish law precluded the Spanish subsidiary from making any royalty payments.

[20] IRC § 958(a)(1)(A); Treas. Reg. § 1.958-1(a)(1).

[21] Treas. Reg. § 1.951-1(a)(1); S Rep No. 1881, 87th Cong, 2d Sess at 254, reprinted in 1962-3 CB at 958.

[22] IRC § 958(a)(2); Treas. Reg. § 1.958-1(b). IRC § 958(a) creates some difficulty in referring to direct and indirect ownership, in its caption and to direct ownership in I.R.C. § 958(a)(1)(A), but then referring to indirect ownership only obliquely in I.R.C. § 958(a)(1)(B), (2).

[23] On substance over form in the determination of voting power of the controlled foreign corporation for purposes of Subpart F, see, e.g., Rev. Rul. 70-426; Garlock Inc. v. C.I.R., 489 F.2d 197 (2d Cir. 1973). CCA, Inc. v. C.I.R., 64 T.C. 137 (1975), acq. recommended, 1976 WL 39260 (I.R.S. AOD 1976) and acq., 1976-2 C.B. 1 and nonacq., 1982-2 C.B. 1, acq. with Estate of Weiskopf v. C.I.R., 64 T.C. 78 (1975), acq. recommended, 1975 WL 38132 (I.R.S. AOD 1975) and aff’d, 538 F.2d 317 (2d Cir. 1976). See Framatome Connectors U.S., Inc. v. C.I.R., 118 T.C. 32 (2002), aff’d, 108 Fed. Appx. 683 (2d Cir. 2004) where the Tax Court ruled that the taxpayer was not a CFC in the year at issue under IRC §§ 957(a)(1) and (2). The Court examined the voting power and stock value tests in finding that the taxpayer could not rely on a substance over form argument since their primary motivation was tax avoidance. The taxpayer’s position regarding whether taxpayer’s subsidiary was a CFC was tax motivated because the Tax Court found that taxpayer’s representations were incomplete and unconvincing. The taxpayer denied having Subpart F income for the years following the years at issue, and then ask the Tax Court to infer that they had little or no Subpart F income for the years at issue. The taxpayer cited nothing in the record relating to the years at issue to support their contention.

[24] CCA 201104034, also finding that when a person who is a U.S. shareholder as a result of informal voting power arrangements fails to file Form 5471, the statute of limitations for assessing tax imposed with respect to any tax return, event, or period to which the information required to be reported on the form relates will not begin to run under IRC § 6501(c)(8) until the shareholder files the required Form 5471. Similarly, a person who is a U.S. shareholder as a result of informal voting power arrangements is subject to the penalties under IRC § 6038 for failure to file Form 5471. Garlock Inc. v. C.I.R., 58 T.C. 423 (1972), aff’d, 489 F.2d 197 (2d Cir. 1973), in which a U.S. corporation reduced its title ownership in the voting stock of a Panamanian subsidiary from 100% to 50% in order to avoid tax under the then recently enacted CFC provisions. (If U.S. ownership by vote and value had been no more than 50%, the subsidiary would not be considered a CFC.) In the recapitalization, preferred shares were issued to foreign investors who nominally received 50% of the voting power. The court nevertheless held that the voting power of the stock was in reality retained by the U.S. corporation, which was therefore required to include subpart F income from the subsidiary. In reaching its determination that the voting power of the preferred shareholders was illusory, the court considered that the stock had been deliberately placed with investors who would vote their stock as instructed, the transfer of shares was prohibited without prior written consent, and even though the investors could have technically voted independently, there was no evidence that they did, and the board in fact always consisted of the U.S. corporation’s officers. Also of relevance was a report by the president of the U.S. corporation to the board of directors of the subsidiary, which proposed the recapitalization and explained that the reason was to avoid the tax result at issue. The case also contained dictum on the recharacterization of debt and equity under I.R.C. § 385, in this context. In Koehring Co. v. U.S., 583 F.2d 313 (7th Cir. 1978), a foreign corporation was determined to be a CFC based on an informal side agreement granting actual voting power. The court found that the U.S. shareholder had arranged matters so that he had not actually divested himself of effective control.

[25] Rev. Rul. 84-72.

[26] IRC § 958(a)(2); Treas. Reg. § 1.958-1(b). The foreign trust or foreign estate, as defined in IRC § 7701(a)(31), is that estate or trust, the income of which, being from sources outside the United States and not effectively connected with the conduct of a trade or business within the United States, is not includable in gross income.

[27] IRC § 958(a)(2); Treas. Reg. § 1.958-1(b).

[28] Treas. Reg. § 1.958-1(c)(2).

[29] Treas. Reg. § 1.958-1(c)(2).

[30] Treas. Reg. §§ 1.958-1(c)(2), 1.951-1, 1.957-1. On substance versus form in the definitions of the United States shareholder and the controlled foreign corporation.

[31] IRC § 958(a)(2); Treas. Reg. § 1.958-1(b).

[32] Treas. Reg. § 1.958-1(b) which contains the following example. M Corporation, a domestic corporation, owns 75% of the one class of stock in R Corporation, a foreign corporation, which in turn owns 80% of the one class of stock in S Corporation, a foreign corporation, which in turn owns 90% of the one class of stock in T Corporation, a foreign corporation. R corporation is considered as owning 80% of the 90% of the stock which S corporation owns in T Corporation, or 72% (.80 × .90). Corporation M is considered as owning 75% of such 72% of the stock in T Corporation or 54% (.80 × .90 × .75). Since M Corporation is a domestic corporation, the attribution stops with M Corporation even though, illustratively, such corporation is wholly owned by domestic corporation N.

[33] IRC § 958(b); Treas. Reg. § 1.958-2(a).

[34] IRC § 958(b); Treas. Reg. § 1.958-2(a).

[35] Treas. Reg. § 1.958-2(e). IRC § 318(a)(4).

[36] Treas. Reg. § 1.958-2(f)(1)(iv). IRC § 318(a)(5)(D); Treas. Reg. § 1.958-2(f)(2) (coordination of competing attribution rules).

[37] IRC § 318(a)(1). Treas. Reg. § 1.958-2(b)(1), (2).

[38] IRC § 958(b)(1); Treas. Reg. § 1.958-2(b)(3).

[39] IRC § 958(b); Treas. Reg. § 1.958-2(b)(3). IRC § 958(b)(1) and Regulations refer to the individual where the person seems intended. See IRC § 7701(a)(1) for a definition of person as including individual and trust or estate. See General Explanation of the Tax Reform Act of 1976, prepared by the Staff of the Joint Committee on Taxation 229 (1976). Stock owned by nonresident aliens continues to be attributed to individual United States persons under the family attribution rules, for the purpose of determining whether United States shareholders of the controlled foreign corporation own 25% or more of the total combined voting power of the domestic corporation, immediately after the acquisition of any of its stock by the controlled foreign corporation. This determination of the degree of ownership by United States shareholders is performed, in turn, for purposes of an exception to the controlled foreign corporation’s investment in United States property.

[40] Treas. Reg. § 1.958-2(c)(1)(ii). IRC § 318(a)(2)(A), (B).

[41] IRC § 958(b)(3); Treas. Reg. § 1.958-2(c)(1)(iii). IRC § 318(b)(8), (a)(2)(C).

[42] IRC § 958(b)(2); Treas. Reg. § 1.958-2(c)(2). IRC § 318(a)(2).

[43] IRC § 318(a)(3)(A), (B). Treas. Reg. § 1.958-2(d)(1)(i), (ii).

[44] IRC § 318(a)(3)(C).

[45] IRC § 318(a)(5)(C); Treas. Reg. § 1.958-2(d)(2). The IRS is limited by pre-existing regulations that narrow the scope of the statute to which it relates. U.S. v. Colliot, No. AU-16-CA-01281-SS (W.D. Tex. May 16, 2018); see also U.S. v. Wahdan, 325 F. Supp. 3d 1136 (D. Colo. 2018).

[46] Treas. Reg. § 1.958-2(f)(1)(ii). IRC § 318(a)(5)(B).

[47] Treas. Reg. § 1.958-2(f)(1)(iii). IRC § 318(a)(5)(C).

[48] Treas. Reg. § 1.958-2(f)(2).

[49] Treas. Reg. § 1.958-2(f)(2), Example 1(a).

[50] Treas. Reg. § 1.958-2(f)(2), Example 1(a). Thus, the whole exceeds the sum of the parts; basically, you don’t disregard portions attributed to others. Presumably, M Corporation would be attributed A’s proportional share in R Corporation were A’s share in M Corporation equal to or greater than 50%. Treas. Reg. § 1.958-2(d)(1)(iii).

[51] Treas. Reg. § 1.958-2(f)(2), Example 1(b).

[52] Treas. Reg. § 1.958-2(f)(1)(iii).

[53] See Dominion Res., Inc. v. U.S., 681 F.3d 1313 (Fed. Cir. 2012).

[54] U.S. v. Colliot, No. AU-16-CA-01281-SS (W.D. Tex. May 16, 2018); see also U.S. v. Wahdan, 325 F. Supp. 3d 1136 (D. Colo. 2018).

[55] 163 Cong. Rec. 58,110 (daily ed. Dec. 19, 2017) (statement of Sen. David Perdue).

[56] 163 Cong. Rec. 58,110 (daily ed. Dec. 19, 2017) (statement of Sen. Orrin Hatch).

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