IRA-Owned FSCs

The use of foreign sales corporations (FSCs) can result in significant income tax savings to manufacturers and distributors with income from export sales. The tax savings is in the form of a permanent tax reduction on a portion of the earnings from export sales. The reduction is based on a stated percentage (15/23 for corporate-owned FSCs, 16/23 for all others) of the FSC's earnings, computed using allowable administrative pricing rules. Dividends paid by a FSC to a C shareholder can be offset completely by the dividends-received deduction (DRD). Therefore, a FSC can reduce the tax paid on earnings from foreign exports by 15/23 of the earnings determined to be earned by the FSC.

Historically, FSCs have been considered feasible only in a C corporation environment; only C corporations can claim a DRD for dividends from an FSC. Likewise, FSCs are normally created under the ownership of a related supplier. There are, however, alternatives for the ownership of FSCs that might increase their effectiveness. In addition, the use of an interest-charge domestic international sales corporation might also be considered under certain circumstances.

Individual retirement account (IRA)-owned FSCs can provide significant tax benefits, particularly in an S environment. Because S corporations are not allowed a DRD, an FSC owned by a related S corporation supplier provides no benefit; in fact, the result is a slightly higher effective tax rate. An FSC owned directly by the shareholders will yield no tax benefit, for the same reason. However, an IRA-owned FSC can be used to receive tax-free distributions from the FSC. A second benefit is that the dividends from the FSC can be reinvested tax-free and remain tax-free until distributed from the IRA. Exhibit 1 illustrates the potential tax benefit of an IRA-owned FSC in an S environment.

The use of an IRA-owned FSC requires that the prohibited transaction rules be considered; certain activities that the FSC normally engages in should be avoided. Careful drafting of FSC documents should reduce any exposure.

An additional benefit derived from using an IRA-owned FSC is having key employees, who are not owners of the related supplier, own FSC stock through their own IRAs. As long as the employees own less than 50% of the FSC's stock, the administrative pricing rules can be used to compute the FSC's commissions. This allows key employees to participate in profits generated from export sales without ownership of the company. There is also a significant benefit to the employee, not only to the extent of the dividends received from the FSC, but also as a result of the ability to reinvest those dividends tax-free in the IRA.

Similarly, children and grandchildren of the owners of the related supplier can own FSC stock through IRAs. This can be an effective tool to transfer wealth from the owners of the related supplier to their descendents, with a deductible expense to the related supplier. There may be gift tax implications for FSC ownership by the children, grandchildren and other relatives of the owners of the related supplier, however. In Rev. Rul. 81-54, commissions paid for no significant services to a DISC owned by persons related to the owner of the related supplier were gifts subject to gift tax. There is some question, however, whether this ruling applies to FSCs or even whether it is valid for DISCs. Regardless of the gift tax implications, the advantages of moving assets from the related supplier owner's estate, combined with the tax-free investment of those assets, may be beneficial even if gift tax is imposed.

Consideration should also be given to using Roth IRAs, if the income level is met. Although the owners of the exporter will typically not be eligible to create a Roth IRA, it may be a viable option for the owners' descendents or the exporter's employees. A Roth IRA provides an additional tax benefit; distributions are not taxable if certain requirements are met.

Although an IRA or other qualified plan-owned FSC may be the only option considered when the related supplier is an S corporation, consideration should also be given to this arrangement when the related supplier is a closely held C corporation. The benefits of IRA-owned FSCs are equally applicable, regardless of whether the related supplier is an S or a C corporation.

The first step in setting up an IRA-owned FSC is to create and fund the IRA. Care should be taken in choosing the IRA custodian, as some custodians are not familiar with (and, therefore, are not comfortable with) an IRA investing in a FSC. Some custodians have affiliates that operate as management companies in the more popular FSC locations. While this can provide obvious benefits, it is not required.

Once the IRA is established and funded, the FSC should be set up. The custodian should be provided with written authority to make the payments necessary to set up the FSC. Required payments might include incorporation fees, annual business licenses, set-up fees to the management company and professional fees. Once the FSC is established, the owner of the IRA should instruct the custodian in writing to buy the FSC stock. If there will be multiple owners of a FSC, the instructions should state the percentage each IRA will own.

From Michael W. Granberg, CPA, Oak Brook, IL

Subpart F Treatment of Hybrid Branches and Partnerships

In July 9, 1999, the Treasury issued proposed regulations that withdrew Notice 98-35 and imposed at least a six-year moratorium on hybrid branch regulations. Notice 98-35 was issued in June 1998 to announce the Service's plans to withdraw temporary and proposed regulations on the use of controlled foreign corporations (CFCs) and hybrid branches under subpart F. Notice 98-11, which announced the IRS's intent to issue those regulations, was also withdrawn at that time.

Notice 98-35 was issued in response to opposition from Congress, taxpayers and practitioners to the proposed and temporary regulations. It indicated that the Service intended to issue a new notice of proposed rulemaking covering CFCs, hybrid transactions and subpart F income. The IRS did not plan to finalize the regulations before Jan. 1, 2000, but they would be effective for all payments made under hybrid arrangements on or after June 19, 1998, unless otherwise specified. Permanent relief was provided for any payments made under hybrid arrangements entered into before June 19, 1998, as long as the arrangement was not substantially modified after that date.

A hybrid branch is one that is viewed to be part of a CFC for U.S. income tax purposes, but is treated as a separate entity under the laws of the foreign jurisdiction in which it is organized. Notice 98-11 identified arrangements that the Service defined as contrary to the policies and rules of subpart F. These arrangements involve the use of deductible payments from the CFC to the hybrid branch, thereby reducing the CFC's taxable income and foreign income tax. The hybrid branch is created in a low-tax jurisdiction; therefore, the corresponding income recognition is taxed at a lower rate than the payor is subject to. As a result, total foreign income taxes are reduced. The income of the hybrid branch is passive income to which the IRS believes the subpart F rules were intended to apply; however, because of the structure of the arrangement, this income would not otherwise be taxed under subpart F.

With the exception of the effective date of the regulations, the new proposed regulations are substantially the same as the proposed and temporary regulations issued in 1998. Under the new proposed regulations, certain payments made between a CFC and its hybrid branch (or between hybrid branches of the CFC) may give rise to subpart F income. The new rules apply to "hybrid branch payments," defined as payments made between two separate entities under the laws of the foreign jurisdiction in which the payor is taxed but which, under U.S. income tax principles, are not considered income to the recipient, because the payments are deemed made between two parts of a single entity.

Under Prop. Regs. Sec. 1.954-2(a)(6), if certain conditions are present, non-subpart F income of the payor will be recharacterized as subpart F income to the extent of any hybrid branch payments. However, the amount recharacterized as subpart F income continues to be limited to the amount of the CFC's earnings and profits attributable to non-subpart F income. The conditions for reclassifying non-subpart F income to the extent of hybrid branch payments are:

1. A hybrid branch payment reduces the payor's foreign tax;

2. A hybrid branch payment would have been foreign personal holding company income (FPHCI) if made between separate CFCs; and

3. There is a disparity between the effective tax rate on the payment in the payee's hands and the hypothetical tax rate that would have applied had the payment been taxed in the payor's hands.

A hybrid branch payment will reduce the payor's foreign tax if the payment is a deductible expense in the payor's taxing jurisdiction. FPHCI is defined the same as in Regs. Sec. 1.954-2. To determine whether there is a disparity between the effective rate at which the hybrid branch payment is taxed to the payee and a hypothetical tax rate that measures the payor's tax savings from the deductible payment, the percentage tests provided in Regs. Sec. 1.954-3(b) are applied. Therefore, if the tax on the payee is less than 90% of, and at least 5 percentage points less than, the hypothetical tax that would have applied to the payor, there will be a disparity between the effective tax rates.

Under the proposed regulations, the CFC and the hybrid branch (or hybrid branches) are treated as separate corporations only for the purpose of recharacterizing the non-subpart F income as subpart F income. For all other purposes, the CFC and its hybrid branch will not be treated as hybrid branches.

Under certain circumstances, the recharacterization rule would also apply to a CFC's proportionate share of any hybrid branch payment made between a partnership in which the CFC is a partner and a hybrid branch of the partnership, or between hybrid branches of such partnership. If the partnership is treated as fiscally transparent in the CFC's taxing jurisdiction, any hybrid branch payments will be treated as being made directly between the CFC and the hybrid branch. If the partnership is treated as a separate entity in the CFC's taxing jurisdiction, the recharacterization rules are applied to the partnership as if it were a CFC.

Prop. Regs. Sec. 1.954-1(c)(1)(I)(B) provides rules to prevent expenses that would normally be allocable to a CFC's subpart F income from being allocated against subpart F income resulting from the payment giving rise to the expense. This limit on the allocation of expenses applies (1) to the extent such payment is included in the CFC's subpart F income, (2) if the expense arises from a payment between a CFC and a partnership not treated as fiscally transparent and (3) the payment would have been subject to the recharacterization rule had it been a hybrid branch payment.

The proposed regulations also address the application of the related-person exceptions to the FPHCI rules in the context of income passing through a partnership involving hybrid branches. Certain types of income are excluded from the definition of FPHCI if received from related corporations. These exceptions apply to interest and dividends, when the related corporate payor is organized in the same country as the payee and uses a substantial portion of its assets in a trade or business in that country.

Under the proposed regulations, if a partnership receives an item of income that reduces the tax liability, the related-person exception would apply to a CFC partner only if (1) the exception would have applied had the CFC earned the income directly and (2) the partnership is organized and operates in the CFC's country of incorporation, the partnership is treated as fiscally transparent in the CFC's countries of incorporation and operation or there is no significant disparity between the effective rate of tax imposed on the income and the rate of tax that would be imposed on the income if earned directly by the CFC partner.

Finally, the regulations contain provisions that apply the related-person exceptions to certain payments involving hybrid branches. The related-person exceptions will apply to payments by a CFC to a hybrid branch of a related CFC only if the payment would have qualified for the exception if the hybrid branch had been a separate CFC incorporated in the jurisdiction in which the payment is subject to tax.

The proposed regulations will not be finalized before July 1, 2000. Therefore, as currently proposed, they will not be effective until July 1, 2005 at the earliest. In the interim, Treasury intends to issue a white paper on subpart F; Congress is expected to reexamine all of the anti-deferral regimes applying to foreign operations. Accordingly, the ultimate outcome of the hybrid branch debate is far from certain.

From Michael W. Granberg, CPA, Oak Brook, IL