Generally, a non-U.S. taxpayer that is not engaged in a U.S. trade or business is taxable in the United States only on U.S.-source “fixed determinable, annual or periodical” income (FDAP). Unless an applicable income tax treaty applies to reduce the rate of tax, FDAP income typically will be subject to a 30 percent gross basis withholding tax. Included in the category of FDAP income that is subject to U.S. withholding tax is U.S. source dividends.
While the substantial majority of income tax treaties concluded by the United States reduce or even eliminate the 30 percent withholding tax on U.S.-source dividends, not all foreign jurisdictions have comprehensive income tax treaties with the United States. Therefore, unless a non-U.S. taxpayer is able to satisfy the limitation on benefits (LOB) provision in one of these treaties, any U.S.-source dividends repatriated from the United States to a non-treaty jurisdiction generally will be subject to a 30 percent withholding tax.
There is, however, one technique that is still available that may allow U.S. corporate taxpayers to repatriate profits tax-free from the United States to non-U.S. taxpayers, regardless of whether a treaty exists between the United States and that particular jurisdiction. This strategy takes advantage of the so-called “boot within gain” limitation under Section 356(a) of the Internal Revenue Code.
In general, shareholders that are parties to a nontaxable reorganization do not recognize gain or loss with respect to exchanges of stock and securities in such reorganization. Under Section 356, however, a recipient of money or other property (boot) in a nontaxable reorganization recognizes gain (if any) on the transaction in an amount not in excess of the sum of such money and the fair market value of such other property. Moreover, if the exchange has the effect of the distribution of a dividend, then all or part of the gain recognized by the exchanging shareholder is treated as a dividend to the extent of the shareholder’s ratable share of the corporation’s earnings and profits. (Whether the exchange has the effect of the distribution of a dividend, see United States v. Clark, 489 U.S. 726 (1989)). The remainder of the gain (if any) is treated as gain from the exchange of property.
Accordingly, if a shareholder receives boot in connection with a corporate reorganization, the amount that the shareholder is required to recognize as income is limited to the amount of gain realized in the exchange (i.e., the boot within gain limitation). This rule applies regardless of whether the property received would otherwise be considered to be a dividend for U.S. federal income tax purposes.
Consider the example of a Brazilian Parent Co.
What is notable about this provision is that it applies not only in a purely domestic setting, but it also applies in the cross-border setting. For example, assume a Brazilian parent corporation wholly owns multiple U.S. operations companies. Also assume that the shares of the U.S. subsidiaries have substantially increased in value and that one or more of the companies has excess cash that it desires to repatriate to Brazil without incurring U.S. withholding tax. Because the United States does not currently have an income tax treaty with Brazil, a dividend paid by one of the U.S. subsidiaries to the Brazilian parent would be subject to a 30 percent U.S. withholding tax.
In an attempt to minimize the U.S. withholding taxes in this situation, the Brazilian parent transfers the shares of the U.S. subsidiaries to a Brazilian holding company. Assume that the Brazilian holding company is owned 75 percent by the existing Brazilian parent and 25 percent by a newly formed Brazilian company (which in turn is wholly owned by the existing Brazilian parent). Subsequently, an IRS Form 8832 (i.e., a “check-the-box” election) is filed on behalf of the Brazilian holding company converting it from a corporation into a partnership for U.S. federal income tax purposes. (The Brazilian parent’s direct ownership of the Brazilian holding company needs to be less than 80 percent so that the deemed liquidation that results when the check-the-box election is filed is not treated as a nontaxable parent subsidiary liquidation under Section 332).
As a result of this deemed conversion, the Brazilian holding company is treated as if it distributed all of its assets (i.e., the shares of the U.S. subsidiaries) and liabilities to its shareholders in liquidation of the corporation, and immediately thereafter, the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership. These deemed transactions should have no adverse U.S. federal income tax consequences, but will result in the shares of the U.S. subsidiaries being stepped up to fair market value for U.S. federal income tax purposes.
Subsequently, in a transaction characterized as a “D” reorganization for U.S. federal income tax purposes, one of the U.S. subsidiaries merges into another one of the U.S. subsidiaries (or into a disregarded U.S. LLC wholly owned by one of the U.S. subsidiaries) and, in exchange, the Brazilian holding company receives solely cash as consideration in the merger. As a result of the shares of the U.S. subsidiaries being recently stepped up to fair market value pursuant to the check-the-box election, there will be no “gain” in the reorganization. Therefore, the boot (i.e., the cash) received by the Brazilian holding company in the reorganization will be received tax free under the “boot within gain limitation” rule, even though it would normally be treated as a dividend subject to a 30 percent withholding tax.
This is known as an “all cash” D reorganization, which have been approved by the IRS and Treasury in regulations issued a few years ago. It should be noted that a transaction structured as an “F” reorganization under Section 368(a)(1)(F) (i.e., a mere change in identity, form, or place of organization of one corporation) would not produce the same results, despite such a transaction being easier to structure, because the regulations would treat the distribution separate and apart from the reorganization and cause it to be taxable.
As a result, the combination of Section 356(a) and the check-the-box rules allows for the repatriation of cash by the U.S. subsidiary to Brazil without triggering a U.S. withholding tax. This strategy is extremely beneficial when it is not practical to liquidate a U.S. operating company, which may be a simple solution to avoiding U.S. withholding tax on the repatriation of profits in certain situations.