The Tax Cuts and Jobs Act (“Tax Reform” or “TCJA”) expanded the pool of potential U.S. shareholders by repealing the provision that prohibited the attribution of stock ownership from a foreign person to a U.S. person, effective for the last taxable year of foreign corporations beginning before January 1, 2018. Thus, the repeal is effective for 2017 for calendar year entities.
The effect of the repeal is to cause stock owned by a foreign person – whether directly, indirectly (where partners are treated as owning stock held by the partnership) or constructively (effective ownership of stock actually owned by related persons), to be attributed downward to a U.S. person. If that U.S. person is a partnership, each of the partners in that partnership will also be considered to constructively own that stock. Since the attribution rules require upward attribution as well as downward attribution, the potential result is constructive ownership where none existed before.
PE Fund Partnership owns Foreign Corporation. PE Fund’s ownership interest in Foreign Corporation is attributed upward to PE Fund’s partners, including Foreign Individual A. A is also a partner in U.S. Partnership that has no foreign holdings. Prior to the repeal of the prohibition on downward attribution, A’s ownership interest in the PE Fund Partnership was separate from his ownership in U.S. partnership (assuming there are no ties between the two investments). With downward attribution, however, A’s constructive ownership of Foreign Corporation is attributed to U.S. Partnership, which is now considered to own Foreign Corporation. Furthermore, U.S. Partnership’s partners are considered to own Foreign Corporation.
Possible consequences of a U.S. person’s ownership of a foreign corporation
Direct, indirect, and constructive ownership is used to determine whether a U.S. person is a U.S. Shareholder with respect to a foreign corporation. A U.S. shareholder is a U.S. person owning 10% or more of the total combined voting power of all classes of stock of a foreign corporation (before Jan. 1, 2018) or a U.S. person owning 10% or more of the total combined voting power or value of all classes of its stock (after December 31, 2017).
A U.S. shareholder is subject to the repatriation tax on a foreign corporation’s earnings and profits that have not been previously taxed. The U.S. shareholder may also be subject to income inclusion under subpart F and the new Global Low-Taxed Income (“GILTI”) provisions, as well as international information reporting requirements that carry severe penalties for noncompliance.
The IRS’ position in Notice 2018-26
Upward followed by downward attribution is expected to result in significantly expanded constructive ownership of stock of foreign entities by U.S. persons. Therefore, the IRS is planning to issue regulations to the effect that a partnership will not be considered to own stock of a foreign corporation owned by one of its partners if that partner owns less than five percent of the interests in the partnership’s capital and profits.
To be able to determine whether or not the five percent threshold has been reached, each partnership will have to have a good understanding of whether there is constructive ownership within the ranks of its partners, and be able to obtain information regarding its partners’ ownership of foreign entities. Then it has to painstakingly trace ownership percentages. Fortunately, there are limits to attribution and the less than five percent threshold will be helpful, but the effort to figure out the facts is likely to be challenging.
As a threshold matter, it may be challenging simply to obtain information regarding partners’ direct, indirect or constructive ownership interests in foreign entities as the partners are likely to have privacy concerns. However, the partnership will be expected to make a good faith effort to comply. Part of such efforts could include sending out a questionnaire to all partners requesting pertinent information, accompanied by an explanatory note. Reasonable follow up requests should be made, and any information that is publicly available or known to the partnership has to be taken into consideration.
The IRS may provide more specific guidance in the future, but with preparation of 2017 returns underway, partnerships should approach the discovery of whether the partnership and its partners have unwittingly acquired new tax liabilities and reporting obligations with a sense of urgency.
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