When a U.S. company acquires foreign targets, the use of a holding company structure abroad may provide certain global tax benefits. The emphasis is on “global” because standard U.S. benefits such as deferral of income while funds remain offshore may not be available without further planning once a holding company realizes dividends and capital gains. In addition, the operative term is “may provide” because of steps that have been taken by the Organization for Economic Cooperation and Development (“O.E.C.D.”), the European Commission, and the European Parliament to impede tax planning opportunities that have been available to multinational groups for many years.
If we assume the income of each foreign target consists of manufacturing and sales activities that take place in a single foreign country, no U.S. tax will be imposed until the profits of the target are distributed in the form of a dividend or the shares of the target are sold. This is known as “deferral” of tax. Once dividends are distributed, U.S. tax may be due whether the profits are distributed directly to the U.S. parent company or to a holding company created under the laws of a different foreign jurisdiction. Without advance planning to take advantage of the entity characterization rules known as “check-the-box,” the dividends paid by the manufacturing company will be taxable in the U.S.1 If paid to a holding company that is a controlled foreign corporation (“C.F.C.”) for U.S. income tax purposes, the dividend income in the hands of the holding company will be viewed to be an item of Foreign Personal Holding Company Income, which generally will be taxed to the U.S. parent company or any other person that is treated as a “U.S. Shareholder” under Subpart F of the Internal Revenue Code.2
BENEFITS OF HOLDING COMPANIES
Nonetheless, the use of a holding company can provide valuable tax-saving opportunities when profits of the target company are distributed. Historically, the use of a holding company could reduce foreign withholding taxes claimed as foreign tax credits by the U.S. parent. This could be achieved through an income tax treaty, or in the case of operations in the E.U., through the Parent-Subsidiary Directive (the “P.S.D.”). This can result in substantial savings if the operating and tax costs of maintaining the holding company are significantly less than the withholding taxes being saved.
However, as will be described below, the E.U. has taken steps to modify the P.S.D. so that it does not apply when the parent is in turn owned by a company based outside the E.U. and the structure is viewed to be abusive. In addition, all of the European countries discussed in this paper signed the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (the “Multilateral Instrument”) on June 7, 2017. Once the Multilateral Instrument comes into force in a particular European jurisdiction, it will take effect on the first day of the following calendar year or taxable period. Under Article 7 (“Prevention of Treaty Abuse”) of the M.L.I. benefits enjoyed by a European holding company in connection with dividends paid by a European operating company may be limited when
it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement.3
It remains to be seen how this provision will play out for holding companies that are used to channel dividends to U.S. parent companies. Presumably, where the holding company conducts active headquarters operations through its own staff of employees and executives, treaty abuse may be a conclusion that is difficult to reach.
Although the foreign tax credit is often described as a “dollar-for-dollar reduction of U.S. tax” when foreign taxes are paid or deemed to be paid by a U.S. parent company, the reality is quite different. Only taxes that are imposed on items of “foreign-source taxable income” may be claimed as a credit.4 This rule, known as “the foreign tax credit limitation,” is intended to prevent foreign income taxes from being claimed as a credit against U.S. tax on U.S. taxable income. The U.S., as with most countries that eliminate double taxation through a credit system, maintains that it has primary tax jurisdiction over domestic taxable income. It also prevents socalled “cross crediting,” under which high taxes on operating income may be used to offset U.S. tax on lightly-taxed investment income. For many years, the foreign tax credit limitation was applied separately with regard to eight different categories of baskets of income designed to prevent the absorption of excess foreign tax credits by low-tax foreign-source income. In substance, this eviscerated the benefit of the foreign tax credit when looked at on an overall basis. The problem has since eased because the number of foreign tax credit baskets has been reduced from eight to two: passive and general.
The benefit of the foreign tax credit is reduced for dividends received from foreign corporations that, in the hands of the recipient, benefit from reduced rates of tax in the U.S. A portion of foreign dividends received by U.S. individuals that qualify for the 0%, 15%, or 20% tax rate under Code §1(h)(11)(B)(i) are removed from the numerator and denominator of the foreign tax credit limitation to reflect the reduced tax rate.5 This treatment reduces the foreign tax credit limitation when a U.S.-resident individual receives both qualifying dividends from a foreign corporation and other items of foreign-source income within the same basket that are subject to ordinary tax rates.
As a result, a U.S.-based group must determine the portion of its overall taxable income that is derived from foreign sources, the portion derived in each “foreign tax credit basket,” and the portion derived from sources in the U.S. This is not an easy task, and in some respects, the rules do not achieve an equitable result from management’s viewpoint.
1 Treas. Reg. §301.7701-3(a). If an election is made for a wholly-owned subsidiary, the subsidiary is viewed to be a branch of its parent corporation. Intra-company distributions of cash are not characterized as Foreign Personal Holding Company Income, discussed later in the text.
2 There are exceptions to the general characterization of a dividend as an item of Foreign Personal Holding Company Income that might apply. One relates to dividends received from a related person which (i) is a corporation created or organized under the laws of the same foreign country as the recipient C.F.C., and (ii) has a substantial part of its assets used in its trade or business located in that foreign country. See Code §954(c)(3)(A)(i). For a temporary period of time, a look-through rule is provided in Code §954(c)(6), under which dividends received by a C.F.C. from a related C.F.C. are treated as active income rather than Foreign Personal Holding Company Income to the extent that the earnings of the entity making the payment are attributable to active income. This provision is regularly adopted for two-year periods after which it must be re-enacted. The latest version was terminated at the conclusion of 2014.
3 Paragraph 1 of Article 7 of the Multilateral Instrument.
4 Code §904(a).
5 See Code §§1(h)(11)(C)(iv) and 904(b)(2)(B).