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Many of the issues discussed in this article depend on the choice of foreign entity, the tax treatment of that entity under local tax law and the classification of the entity for US income tax purposes. Entity classification issues and the US "check-the-box" regulations will be discussed in detail in a subsequent installment of this article.

Consequences of Entity Classification

Among the US tax issues that depend on whether the foreign entity constitutes a branch, partnership or corporation for US tax purposes are:

• The taxation of the transfers of property, including intangibles, by a US person to the foreign entity. See §§367, 351 and 721 of the Internal Revenue Code.

• The flow-through of early tax losses and subsequent taxable income to the owners if the entity is a partnership or branch (§§704(b), (c) and (d) of the Code), together with possible application of the dual consolidated loss rules of §1503(d) and the loss recapture rules of §367(a)(3)(C), §904(f), and §1.1503-2(g)(2)(iii) of the Income Tax Regulations.

• Possible deferral of US tax on the entity's profits if the entity is a corporation.

• Application of subpart F and passive foreign investment company ("PFIC") rules depends on whether the entity is a corporation or a partnership. See, e.g., Brown Group, Inc. v. Commissioner 102 T.C. 616 (1994) withdrawn, replaced by 104 T.C. 105 (1995), vacated, 77 F.3d 217 (8th Cir. 1996), and the temporary and proposed subpart F regulations concerning partnerships and hybrid branches.

• The effective application of §482 of the Code.

• The nature (direct or indirect), availability and calculation of foreign tax credits, especially the applicability of the §902 non-controlled corporation limitation on foreign tax credits.

• Tax consequences of current distributions (see §§731 and 301 of the Code).

• Tax consequences of a disposition or liquidation of the entity.

• Tax consequences of certain taxable acquisitions (§§338 and 754/743 of the Code).

• Application of the foreign currency rules of §§985-989.

• Application of the US withholding tax rules.

• Reporting requirements (Forms 5471 and 8865, and §§6038, 6038B, 6046A and 6031(e) of the Code).

• Tax treaty issues.

While these issues and corresponding planning opportunities existed before the check-the-box regulations came into play, they are considerably more important now given the greater scope for creating foreign branches, partnerships and hybrid entities.

Transfer of Assets To the Joint Venture

Joint Venture Treated as a Corporation

Section 367 of the Code generally provides that a foreign corporation will not be considered as a corporation for federal income tax purposes and, thus, transfers of property will not qualify for many of the nonrecognition provisions of the Code, such as §351, unless the conditions set forth in §367 and the regu

lations under that section are satisfied. For example, a US shareholder's transfer of most tangible assets to a joint venture corporation in a transaction qualifying under §351 will be tax free if the tangible assets are used in the joint venture's active trade or business outside of the US. See §367(a)(3)(A).

However, the following tangible and intangible assets, as well as the §367(d) intangibles discussed later in this article, cannot be transferred tax free in exchange for stock even if they are used in the joint venture's active trade or business outside the US. Those assets include: inventory; certain copyrights or Branch Loss Recapture. If a US shareholder transfers assets of an existing foreign branch to a foreign corporation in a §367(a) exchange, the transferor may recognize gain if the branch had previously deducted losses for US tax purposes, even if the property is used in the foreign transferee corporation's active business outside the US. See §§367(a)(3)(C) and 904(f), and Treas. Reg. §§1.367(a)-6T, 1.987-3 and 1.1503-2(g)(2)(iii).

A US shareholder's transfer of stock in a foreign corporation to a foreign joint venture corporation in a §351 exchange generally is tax free if the US shareholder enters into a gain recognition agreement. See IRS Notice 87-85, 1987-2 C.B. 395 and Treas. Reg. §1.367(a)-3. However, gain will be recognized if stock of a controlled foreign corporation ("CFC") is transferred by a US shareholder (generally a US person holding at least a 10-percent voting interest) of the stock, if the joint venture corporation is not a CFC of which the US transferor is a US shareholder.

The incorporation of a foreign partnership is treated as an outbound transfer of the partnership's assets by the US partners to the new foreign corporation subject to §367(a). Temp. Treas. Reg. §1.367(a)-1T(c)(3) and Rev. Rul. 80-293, 1980-2 C.B.128.

Section 367(f) replaces pre-1997 law with respect to transfers of property by a US person to a foreign corporation as paid-in surplus or as a contribution to capital. To the extent provided in regulations, the property is treated as sold or exchanged for an amount equal to the fair market value of the property transferred.

Transfer of Intangible Assets to a Joint Venture

Intangible assets covered by §367(d) of the Code include patents, inventions, formulas, processes, designs, patterns, know-how, copyrights, trademarks, franchises, licenses, contracts, customer lists, technical data or any "similar item." Transfers of these intangibles do not qualify for tax-free treatment under §§351(a) and 367(a)(1). However, foreign goodwill and going concern value are not tainted §367(d) intangibles. Foreign goodwill and going concern value are deemed to include the right to use a corporate name in a foreign country.

When a US transferor transfers intangible property covered by §367(d) to a foreign corporation in an exchange described in §351, the US transferor must recognize royalty income, subject to periodic adjustment, over the useful life of the intangible, but not exceeding 20 years. Prior to the Taxpayer Relief Act of 1997 (the "1997 TRA"), the deemed royalty income recognized by the US transferor was treated as US-source ordinary income. Under new §367(d)(2)(C), the imputed royalty income is sourced under the same rules as an actual royalty.

The US transferor must recognize an amount determined under the §482 "commensurate-with-income" standard, regardless of a lack of control. Double taxation is likely because the joint venture generally will not be able to deduct the deemed royalty payment for foreign tax purposes.

Section 367(d) is particularly troublesome in connection with foreign joint ventures because the foreign shareholder is often looking to the US shareholder to contribute technology and other intangible property to the joint venture on a royalty-free basis in exchange for an equity interest. Tax planning to avoid §367(d) should be considered before the negotiation of a joint venture agreement begins, as any required restructuring likely would impact the economics of the deal.

If the US shareholder licenses intangible property to the joint venture for a royalty, then §367(d) will not apply. (But see Temp. Reg. §1.367(d)-1T(g)(4)(ii) if the license is a "sham.") Royalties paid by the joint venture to the US shareholder in a royalty-bearing license scenario likely would be foreign source income to the US shareholder and possibly deductible by the joint venture in the foreign jurisdiction.

In lieu of transferring technology for stock, the US joint venturer might consider purchasing its joint venture interest for cash and looking to a royalty stream to recoup its cash investments. If the US joint venturer does not have the requisite cash, it might consider borrowing from, or selling its own stock to, its foreign joint venturer. However, beware of this type of transaction being recharacterized as a §351 exchange and a circular flow of cash.

As an economic matter, the foreign shareholders in the joint venture might be satisfied with certain preferences regarding joint venture dividend distributions to compensate for royalty payments being made to the US transferor. In this case, substance over form issues must be considered.

If the US shareholder has a wholly owned foreign subsidiary that owns the requisite intangible rights or could license these rights from the parent for a royalty, the foreign subsidiary could contribute the intangibles to the joint venture in exchange for stock without §367(d) applying. Also, the US and foreign shareholders could consider entering into a cost sharing arrangement with respect to future technology. If a §367(d) transfer occurs, the US shareholder can receive a cash payment of the deemed royalty from the joint venture tax free within three years of the §367(d) inclusion.

A deemed royalty payment under §367(d) reduces the joint venture's earnings and profits ("E&P") and can be treated as an expense properly allocated and apportion to gross income subject to subpart F in accordance with Treas. Reg. §§1.954-1(c) and 1.861-8.

Section 351 and the Transfer of Intangibles

Generally, when a US shareholder transfers intangible property to a foreign joint venture corporation, it advisable to avoid §351 (and, therefore, §367(d)) treatment).

The IRS requires a transfer of intangibles to constitute a "sale or exchange" for capital gains purposes to qualify for §351 treatment. The agency has ruled that a sale or exchange requires a transfer of "all substantial rights" in the property transferred. See, e.g., Rev. Rul. 69-156, 1969-1 C.B. 101. Transfer of all of the rights one ever had is a sale or exchange. McDonald v. Commissioner, 55 T.C. 840 (1971) acquiesced.

On the other hand, the courts have held that a transfer of less than all of the substantial rights in property may qualify as a §351 exchange. See DuPont v. US, 471 F.2d 1211 (Ct. Cl. 1973) (transfer of nonexclusive rights qualifies under §351), and Zachary v. Commissioner, 49 T.C. 73 (1967) (transfer of carved-out oil payment qualifies under §351). Further, three IRS GCMs (GCM 36922 (11/16/76), GCM 37178 (6/24/77) and GCM 38114 (9/27/79)) agree with the holding in DuPont. Nevertheless, the official published IRS position remains that all substantial rights must be transferred. The IRS National Office has recently reviewed its position with respect to §351 transfers of intangibles, but there have been no public pronouncements. (The Bluebook for the 1984 Act indicates that the transfer of a license, such as the one in DuPont, is subject to § 367(d)).

If the transfer of technology in exchange for stock were determined not to qualify under §351, then §367(d) would not apply. However, in that case, the receipt of stock could be treated as a prepaid royalty equal to the value of the stock. If the US transferor controlled the transferee foreign corporation, this lump sum royalty could be subject to adjustment under the commensurate-with-income standard under §482 of the Code.

Partnership Joint Venture

Prior Law

While §721(a) of the Code generally provides nonrecognition treatment for transfers of property to a partnership in exchange for a partnership interest, prior to the 1997 TRA, §1491 imposed a 35-percent excise tax on a US transferor's transfer of appreciated property to a foreign partnership or a foreign corporation. The excise tax was levied on the excess of the fair market value of the property transferred over the sum of its adjusted basis in the hands of the transferor and the amount of the gain recognized by the transferor on the transfer. Section 1491 did not apply to transfers described in §367, however.

If §367 did not apply to the transfer (e.g., because the transferee was a foreign partnership), §1491 could have been avoided if the taxpayer elected under old §1492 to apply the "principles of §367" to the transaction. If a taxpayer made this election, then §367(d) would apply to a transfer of §367(d) intangibles.

A US transferor also could have avoided §1491 by electing under §1057 to treat the transfer as a sale or exchange for US tax purposes and recognize gain equal to the excess of the fair market value of the property transferred over the property's adjusted basis.

Current Law

The 1997 TRA repealed old §§1491-1494. Thus, except as provided in new §§721(c), 721(d) and 367(d)(3), no gain or loss will be recognized on a transfer of property to a foreign partnership in exchange for a partnership interest.

New §721(c) provides that: "The Secretary may provide by regulations that [§721(a)] shall not apply to gain realized on the transfer of property to a partnership if such gain, when recognized, will be included in the gross income of a person other than a United States person." Note that §721(c) applies to transfers to domestic as well as foreign partnerships.

However, notwithstanding new §721(c), new §367(d)(3) provides that: "The Secretary may provide by regulations that the rules of [§367(d)(2)] also apply to the transfer of intangible property by a United States person to a partnership in circumstances consistent with the purposes of [§367(d)]." New §721(d) cross references new §367(d)(3).

Generally, §704(c) and Treas. Reg. §§1.704-3 and 4, require any built-in gain in contributed property to be allocated to the contributing partner upon a subsequent sale or distribution (within seven years) of the contributed property. Section 737 acts as a backstop to §704(c) when a partnership distributes other property to the contributing partner within seven years.

Presumably regulations under new §721(c) will address any perceived possibilities under the current §704(c) regulations for shifting built-in gain from US to non-US persons. Consider whether the current §704(c) anti-abuse provision in Treas. Reg. §1.704-3(a)(10) may, in certain cases, be applicable.

Given that a US partner's distributive share of joint venture partnership income is taxed currently to the US partner and given the operation of §704(c), it is unclear whether the "deemed" royalty mechanism of §367(d)(2) is necessary to achieve the purposes of §367(d).

Analysis

The law regarding whether a transfer of technology to a partnership qualifies as a tax-free §721(a) transfer of property in exchange for a partnership interest is unsettled in much the same way as the law governing §351 transfers of intangibles to corporations discussed above. See, e.g., United States v. Stafford, 727 F.2d 1043 (11th Cir. 1984).

The situation with transfers of intangibles to a partnership is further complicated by the fact that the US transferor may be satisfied to receive only a "profits interest" in the joint venture and no capital account credit, in exchange for the transfer of technology. In this case, even if the transaction does not qualify under §721(a), arguably the US transferor would be taxed only when joint venture profits were subsequently allocated to it.

The reporting requirements of §6038B, as amended by the 1997 TRA, now apply to contributions to foreign partnerships by US persons that hold a 10-percent interest or that transfer more than $100,000 in value during a 12-month period.

Finally, the 1997 TRA amendment to §7701(a)(4) provides authority for regulations that would vary the general rule that a partnership is a domestic partnership if it is created or organized in the US or under the laws of the US. Foreign partnerships are partnerships that are not domestic. Thus, regulations conceivably could classify a US LLC as a foreign partnership if this treatment were "more appropriate." Legislative history states that this should happen only in "unusual cases."

Recognition of Income and Loss

Joint Venture Treated as a Corporation

Subject to the US anti-deferral rules, such as subpart F and the PFIC provisions in the Code, income that is earned by a foreign corporate joint venture generally is not subject to US tax until it is repatriated to the US shareholder. The losses of a foreign corporate joint venture also do not flow through to the US shareholder. If the joint venture corporation is a CFC, the US participant must comply with the reporting requirements of §6038.

Joint Venture Treated as a Partnership

Generally, when a foreign joint venture is treated as a partnership, the income and losses of the joint venture flow through to the US partner. If the use of a joint venture partnership is advisable, but the deferral of income is also desired, a US person could own the joint venture partnership interest through a CFC. Allocations of the joint venture partnership's income, gain, loss, deduction and credit must satisfy ALIGN="JUSTIFY">the "substantial economic effect" requirements of §704(b). Allocations of taxable income also must take into account book/tax differences in contributed property.

Section 6031(e), added in the 1997 TRA, provides that (except as provided in future regulations) a foreign partnership, with no US-source gross income and no gross income effectively connected with the conduct of a US trade or business, is not required under §6031 to file a partnership return even though it may have US partners. Under regulations proposed in January 1998 and finalized in 1999, a foreign partnership that has no gross income that is effectively connected with the conduct of a trade or business within the US, and that would be required to file a partnership return only because it has gross income derived from sources within the US, will be exempt from the requirement to file a partnership return if the following are true:

• no US person has a direct or indirect interest in the partnership;
  
  
• the gross income derived form sources within the US is either fixed or determinable annual or periodical income described in Treas. Reg. §1.1441-2(b) or other amount subject to withholding described in Treas. Reg. §1.1441-2(c);
  
  
• Forms 1042 and 1042-S are filed with respect to all such gross income in accordance with Treas. Reg. §1.1461-1(b) and (c); and
  
  
• the tax liability of the partners with respect to the gross income has been fully satisfied by the withholding of tax at the source, if applicable, under Chapter 3. (This exception applies to tax years ending on or after 90 days from the publication of final regulations, but in no event would it apply to tax years beginning before January 1, 1999.)

However, after the 1997 TRA amendments to §6038, a US person who controls a foreign partnership must file substantially the same information required of CFCs. Future regulations may require US 10-percent partners of a foreign partnership, which is controlled by US 10-percent partners, to furnish information relating to the foreign partnership.

Specific Subchapter K partnership tax elections (e.g., under §754), as well as other tax elections (e.g., under §§195 and 174(a)), generally are made on or with the partnership's tax return. Treas. Reg. §1.6031-1(b)(5) provides that, for a partnership that is not otherwise required to file a return, a return must be filed to make partnership level elections. This return must be signed by all of the partners or by a partner who is authorized (under local law or the partnership's organizational documents) to make the election. See, generally, Atlantic Veneer Corp. v. Commissioner, 812 F.2d 158 (4th Cir. 1987), affirming 85 T.C. 1075 (1987) (a limited partner in a foreign partnership that was not required to file a US partnership return did not make a valid §754 election where it attached a copy of the foreign partnership return (without an English translation) to its US tax return, even though the partnership had in fact made the adjustments to basis provided by §743).

If a foreign partnership fails to file a required US partnership return partnership, deductions and losses can be denied. See §6231(f).

Dual Consolidated Losses

The dual consolidated loss rules under §1503(d) of the Code are quite complex. However, in general, they will not prevent a US partner from claiming its distributive share of a foreign joint venture's losses on its US tax return if the US partner complies with the detailed administrative requirements of Treas. Reg. §1.1503-3(g)(2) and the foreign joint venture's losses are not used to offset the income under foreign tax law of an entity other than the joint venture (e.g., under some form of foreign tax consolidation rules). Dual consolidated losses are subject to recapture upon certain triggering events. See Treas. Reg. §1.1503-2(g)(2)(iii).

Subpart F Issues

Generally, the US shareholders of a CFC must include in their income the CFC's subpart F income to the extent of the CFC's earnings and profits. Subpart F income includes:

Partnership Subpart F Issues -- Brown Group

The Brown Group issue can be framed as follows. Suppose a US corporation has a wholly owned CFC subsidiary in country A ("XCo") and XCo is a partner in a country B partnership (the "Partnership"). Suppose also that the Partnership purchases products that are not manufactured in country A and sells the products to the US parent. Should XCo's distributive share of Partnership income be treated as subpart F sales income under some aggregate or conduit theory of partnership taxation or should the subpart F analysis be applied at the partnership level, treating the Partnership as an entity rather than an aggregate?

In Rev. Rul. 89-72, 1989-1 C.B. 257, the IRS adopted an aggregate approach -- i.e., it treated the CFC (and not the partnership) as the entity that conducts the buying and selling, regardless of the CFC's or the related person's ownership interest in the partnership. Thus, for the IRS, the dispositive issue was not whether a partnership should be considered as a related person under the relevant subpart F provisions, but rather whether a partner should be viewed as stepping into the shoes of its partnership to convert the partnership's earnings into subpart F income.

In Brown Group, Inc. v. Commissioner, 102 T.C. No. 24 (April 12, 1994), withdrawn, the Tax Court initially held that a CFC's distributive share of partnership income is determined at the entity level -- i.e., the partnership is treated as doing the buying and selling. Thus, the Tax Court held no subpart F income arises under pre-1987 law.

However, on rehearing Brown Group, 104 T.C. 105 (1995), the full court reached a different conclusion, holding that the CFC's distributive share of partnership income was subpart F income. The full court arrived at its holding by making generous and technical interpretations of subchapter K and subpart F of the Code. The full court did not specifically adopt the IRS' aggregate approach in Rev. Rul. 89-72, however.

On appeal, 77 F.3d 217 (8th Cir. 1996), nonacquiesed, the Eighth Circuit agreed with the first Tax Court decision stating that income earned by the partnership should be characterized at the partnership or entity level and should retain its character when allocated to the individual partners. The Eighth Circuit noted that partnership anti-abuse regulations enable the IRS to recast partnership income under subpart F.

Attempts to Address Brown Group

IRS Notice 96-39 provides that the agency will issue subpart F regulations describing how to apply the aggregate approach to determine whether a CFC's distributive share of partnership income is subpart F income. Partnership anti-abuse regulations provide that the IRS can treat a partnership as an aggregate to carry out the purpose of any provision of the Code or regulations, unless: (1) entity treatment is specifically prescribed; and (2) that treatment and ultimate tax results are clearly contemplated. See Treas. Reg. §1.702-2(e).

In September 2000, the IRS issued a revised set of proposed regulations under §§702, 952, 954 and 956 of the Code. Those regulations were supposed to clarify that the aggregate approach to partnerships applies to determine the treatment of a CFC's distributive share of partnership income.

In June 1998, IRS Notice 98-35 withdrew Notice 98-11 and said that the Treasury Department and the IRS would withdraw the regulations issued under that Notice. The new Notice also said that no regulations on foreign hybrid arrangements would be finalized before January 1, 2000. Thus, this deferred the issue, but did not completely eliminate it. The regulations, when finalized, would apply to all payments made on or after June 19, 1998, except as follows.

Permanent "grandfathered" relief is given for hybrid branch arrangements entered into before June 19, 1998, so long as the arrangement is not substantially modified, thereafter. Transitional relief is provided for arrangements entered into on or after June 19, 1998. The transitional relief will last for five years from the date

of finalization of regulations (no earlier than January 1, 2005), unless the arrangement is substantially modified after finalization of the regulations.

Under the transitional relief provision, the amount that can be stripped away from any country is up to 50 percent of the non-subpart F active earnings of the commonly controlled business in that country (best of the last seven years ending before June 19, 1998). For newly established CFCs (less than seven years old), the amount is 50 percent of a 20-percent return on active equity on June 19, 1998. Hybrid branch payments in excess of the limit will be treated as subpart F income under the hybrid branch rules. However, this treatment will be limited to post-June 18, 1998 arrangements. These arrangements must be disclosed on an attachment to Form 5471. q

[In the next installment of this article, the author examines foreign tax credit planning issues and the disposition of a foreign joint venture, among other things.]

© James C. Garahan. James C. Garahan is a partner at Fenwick & West LLP in Palo Alto, California. He can be contacted by telephone at 650-858-7204.

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