On November 30, 2015, the UK tax authorities at HM Revenue and Customs (HMRC) reached an agreement with Jersey about the interpretation of the company residence tie-breaker provision of the Jersey-UK income tax treaty. After reviewing other income tax treaties that contain similar provisions, HMRC will now take the view that the tie-breaker clause will be utilized to determine where a company will be treated as a resident for tax purposes pursuant to the affected income tax treaties.
This represents a significant departure from HMRC’s previous view and could have important implications for many U.S. taxpayers. Under HMRC’s prior interpretation, a dual-resident company (e.g., a company resident in the UK by virtue of its place of incorporation but resident in the other jurisdiction by virtue of its management and control) was not treated as a resident of either jurisdiction for purposes of the treaty and therefore was not eligible for treaty benefits.
HMRC now takes the view that, for the purposes of applying the affected treaties, these treaty provisions should be read as treating such a dual-resident company as a resident of the jurisdiction in which it is managed and controlled. When a company is managed and controlled in both the UK and the other treaty jurisdiction, however, the company will not be eligible for treaty benefits.
The affected countries are as follows: (i) Antigua; (ii) Belize; (iii) Brunei; (iv) Burma; (v) Greece; (vi) Grenada; (vii) Guernsey; (viii) Isle of Man; (ix) Jersey; (x) Kiribati; (xi) Malawi; (xii) Monserrat; (xiii) St Kitts & Nevis; (xiv) Sierra Leone; (xv) Solomon Islands; and (xvi) Tuvalu.
Of the above list of countries, three such countries do not impose any corporate income tax: (i) Guernsey, (ii) Isle of Man, and (iii) Jersey. Therefore, as further discussed below, there are a number of potential tax planning opportunities for U.S. businesses with operations outside the United States to eliminate UK corporate taxes and at the same time obtain deferral of the income from a U.S. federal income tax perspective.
‘Management and Control’ in the Non-U.S. Context
For U.S. federal tax purposes, the place of incorporation is the sole factor in determining whether a corporation is domestic or foreign. In many non-U.S. jurisdictions, however, a foreign corporation is considered a “resident” of a particular jurisdiction if that corporation is either incorporated in such jurisdiction or is managed and controlled in that jurisdiction. For this purpose, management and control generally exists in a particular jurisdiction if regular board of directors meetings are held in that jurisdiction.1
A “dual-resident corporation” is a foreign corporation that is created or organized in one jurisdiction but managed and controlled in a second jurisdiction. Generally, when a dual-resident corporation exists, the place where such corporation is resident for tax purposes depends on whether an income tax treaty is in effect between these two foreign jurisdictions.
An income tax treaty’s corporate “tie-breaker” provision typically provides that the corporation will be treated as a resident (and therefore taxed) in the jurisdiction where the corporation’s “effective management is situated.” If no treaty exists, however, a dual-resident corporation may be subject to tax in both jurisdictions (i.e., the jurisdiction where it is created or organized and the jurisdiction where the effective management is situated). Because of the manner in which the United States taxes corporations that are formed in the United States, this would be the result if a corporation were formed in the United States but managed and controlled in a foreign jurisdiction (i.e., it would become a dual-resident corporation and potentially subject to double taxation).2
Controlled Foreign Corporations
For U.S. federal income tax purposes, certain categories of income (known as “Subpart F income“) of a “controlled foreign corporation” (“CFC”) is taxable annually to the U.S. shareholders of the CFC, whether or not such shareholders receive any actual distributions. Under one category of Subpart F income (foreign personal holding company income, or “FPHCI”), certain types of income received by a CFC from a related corporation that is created or organized under the laws of the same foreign country in which the CFC is created or organized will not be treated as FPHCI as long as the related corporation has a substantial part of its assets used in its trade or business located in that same foreign country (the “same-country exception”). This rule applies even if the CFC is “managed and controlled,” and therefore resident, in a different jurisdiction than the related foreign corporation. Similarly, a CFC will generate “foreign base company services income”, a second category of Subpart F income, only if, among other things, the income is derived from the performance of services outside of the jurisdiction in which CFC is created or organized. A similar, same-country exception applies for purposes of a third category of Subpart F income, foreign base company sales income, which is more fully described below.
The above provisions, among others, thus may allow a taxpayer to form a foreign corporation in a particular jurisdiction while moving the management and control of such entity to a more favorable taxing jurisdiction, and at the same time avoid certain adverse U.S. federal income tax consequences under Subpart F.
US Tax Planning Avoiding Foreign Personal Holding Company Income
As noted above, one of the primary categories of Subpart F income consists of FPHCI. FPHCI includes most forms of passive income, such as dividends, interest, royalties, rents, annuities, and the excess of gains over losses from the sale or exchange of property that gives rise to passive income.3 A major exception from FPHCI applies for dividends and interest received from a related person that (1) is a corporation created or organized under the laws of the same foreign country under the laws of which the CFC is created or organized, and (2) has a substantial part of its assets used in its trade or business located in such same foreign country.4 Based on HMRC’s new interpretation of the company tie-breaker provision of certain UK income tax treaties, a tax planning opportunity exists to take advantage of the same country exception from FPHCI while minimizing UK corporate income tax.
- Example: A U.S. corporation (USP) owns 100% of the stock of FC1, which in turn owns 100% of the stock of FC2. FC1 was formed in the UK but is managed and controlled in Jersey, and therefore is treated as a resident of Jersey under the UK-Jersey income tax treaty. FC2 was formed in the UK and is managed and controlled in the UK. FC1 lends money to FC2 at market rates. Assuming the interest paid by FC2 does not reduce FC2’s Subpart F income or create (or increase) a deficit in FC2’s E&P that may reduce FC2’s Subpart F income, the interest payment will be exempt from Subpart F income under the same-country exception. Thus, USP will have the ability to defer paying U.S. federal income tax on this income until it is distributed to USP. These rules should apply irrespective of whether FC1 is considered to be a tax resident of Jersey, and therefore, subject to corporate income tax at a 0% rate, as opposed to the 20% corporate income tax rate currently in effect in the UK.
Avoiding Foreign Base Company Sales Income
Another planning opportunity is to use a dual-resident UK company to avoid foreign base company sales income (“FBCSI”). FBCSI is income of a CFC from the sale of personal property that is purchased from, or on behalf of, or sold to, or on behalf of, a related person where the property is both manufactured and sold for use outside the CFC’s country of incorporation. If the CFC manufactures the property that it sells, the sales income generally will not be subject to the FBCSI rules. The FBCSI rules are intended to prevent the deflection of income from the jurisdiction in which the goods are manufactured to a low-tax jurisdiction. Thus, when the manufacturing is carried on by related corporations, the FBCSI rules often will apply.
- Example: CFC2 is a manufacturing corporation incorporated in the UK. The U.S. parent of CFC2 forms a sister subsidiary corporation, CFC1, which is also incorporated in the UK but is resident of the Isle of Man under the UK-Isle of Man income tax treaty (i.e., because it is managed and controlled in the Isle of Man). CFC1 enters into a contract manufacturing arrangement for CFC2 to manufacture goods from raw materials that CFC1 purchased from the U. S. parent and provided to CFC2 (thus leaving less profit in CFC2). CFC1 can then sell through a commissionaire (or branch) established in the country of sale.
CFC1 will not be taxed on its sales profits in the UK because the UK treats it as a non-resident based on the UK-Isle of Man tie breaker provision explained above. For U.S. tax purposes, however, CFC1 is treated as a UK corporation because it was incorporated in the UK. For the FBCSI rules to apply, the sales income would have to be derived in connection with the sale of products both manufactured and sold for use outside CFC1’s country of incorporation (here, the UK). In this case, if properly structured, CFC1’s sales income should not be considered FBCSI because the income is derived from the sale of products manufactured in the UK and thus the “same country exception” applies. Thus, CFC2 may reduce its tax burden in the UK without any corresponding subpart F income in the hands of CFC1 because of these inconsistencies between the U.S. and foreign determinations of where the corporation resides.
Implications to other US Tax Provisions
Other Sections of the Code that allow for similar planning include the foreign base company services provisions under Section 954(e) and the related party factoring income provisions of Section 864(d)(7). Similar planning also was available under Section 7874, relating to corporate inversions, until Treasury and IRS recently issued a Notice (2015-79) indicating that they plan to issue regulations providing that benefits are not available unless the foreign corporation in question is subject to tax as a resident of the relevant foreign country in which it was incorporated. Thus, this Notice would eliminate the possibility of exploiting different residency standards in the U.S. versus the foreign country in the context of Section 7874.
1 Other relevant factors in determining where a company’s management and control is located may include (1) the jurisdiction where a local office or address exists, (2) the jurisdiction where a local bank account is maintained, and (3) the location where the company’s books and records are maintained. In addition, in certain jurisdictions a company will be considered a resident only if the day-to-day management activities occur in such jurisdiction.
2 Of course the FTC provisions generally would provide relief from double taxation. The U.S. also has special rules for “dual-chartered” entities (i.e., those entities that are treated as formed in more than one jurisdiction). See Reg. 301.7701-2(b)(9) (which treats dual-chartered entities as per se entities under the entity classification regime). Similar to dual-resident companies, dual-chartered entities that are formed in the U.S. continue to be taxed as domestic corporations.
3 Section 954(c)(1).
4 Section 954(c)(3)(A). When Section 954(c)(6) is effective, it provides even broader benefits than does the same country exception for FPHCI. Section 954(c)(6) first became effective in 2006. Under that provision, dividends, interest, rents, and royalties received or accrued by a CFC from a CFC which is a related person will not be treated as FPHCI to the extent attributable or properly allocable to income of the related CFC that is neither Subpart F income nor effectively connected income (“ECI”). Section 954(c)(6) expired as of January 1, 2015 and, at the time of writing this article, is not effective. Thus, while taking advantage of the same-country exception clearly provides significant tax benefits, when Section 954(c)(6) is effective, that provision may provide even more benefits. There are also other ways to potentially avoid FPHCI income in such cases, including filing a check-the-box election on FC2 in the above fact pattern. Such elections are not always available, however, as in the case of entities that are classified as per se corporations under U.S. rules.