4. Amendments Affecting Tax Treatment of Controlled Foreign Corporations and Their Shareholders (secs. 1021 through 1024 of the Act and secs. 951, 954, 956, 958, 963, and 1248 of the Code)

Prior law

The United States imposes its income tax upon the worldwide income of any domestic corporation, whether this income is derived from sources within or from without the United States. A tax credit (subject to limits) is allowed for foreign income taxes imposed on its foreign source income.

Foreign corporations generally are taxed by the United States only. to the extent they are engaged in business in the United States (and to some extent on other income derived here). As a result, the United States generally does not impose a tax on the foreign source income of a foreign corporation even though it is owned or controlled by a U.S. corporation or group of U.S. corporations (or by U.S. citizens or residents). Such a corporation is subject to tax, if at all, by the foreign country or countries in which it operates.

Generally, the foreign source income of a foreign corporation is subject to U.S. income tax only when it is actually remitted to the U.S. corporate or individual shareholders as a dividend. The tax in this case is imposed on the U.S. shareholder and not the foreign corporation. The fact that no U.S. tax is imposed in this case until (and unless) the income is distributed to the U.S. shareholders (usually corporations) is what is generally referred to as tax deferral.1

An exception is provided, however, to the general rule of deferral under the so-called subpart F provisions of the Code. Under these provisions income from so-called tax haven activities conducted by corporations controlled by U.S. shareholders is deemed to be distributed to the U.S. shareholders and currently taxed to them before they actually receive the income in the form of a dividend.

The rules generally apply to U.S. persons owning 10 percent or more of the voting power of a foreign corporation, if more than fifty percent of the voting power in the corporation is owned by U.S. persons owning 10 percent interests.

The categories of income subject to current taxation as tax haven income are foreign personal holding company income, sales income from property purchased from, or sold to, a related person if the property is manufactured and sold for use, consumption, or disposition outside the country of the corporation's incorporation, income from services performed outside the country of the corporation's incorporation for or on behalf of any related person, and shipping income (unless reinvested in shipping assets). The statute refers to these types of income as "foreign base company income." In addition, the income derived by a controlled foreign corporation from the insurance of U.S. risks is subject to current taxation. Foreign base company income and income from the insurance of U.S. risks are collectively referred to as subpart F income.

1 Where it is not anticipated that the income will be brought back to the United States. for financial accounting purposes (in accounting for the income of a consolidated group consisting of one or more domestic corporations and its foreign subsidiaries) this income in effect is often shown as income exempt from U.S. tax.

Also earnings of controlled foreign corporations are taxed currently to U.S. shareholders if they are invested in U.S. property. Under prior law, U.S. property was generally defined as all tangible and intangible property located in the United States.

In addition to denying deferral on certain categories of income under subpart F, the Code treats as a repatriation of tax-deferred earnings the gain realized on the sale, exchange or redemption of stock in a controlled foreign corporation (sec. 1248). If a U.S. shareholder owns 10 percent or more of the total combined voting stock of a foreign corporation at any time during the 5-year period ending on the date of the sale or exchange (while the corporation was a controlled foreign corporation), the recognized gain is treated as a dividend to the extent of the foreign corporation's post-1962 earnings and profits attributable to the stock during the time it was held by the taxpayer and was a controlled foreign corporation. Under prior law, however, this provision did not apply to earnings and profits accumulated by a foreign corporation while it was a less-developed country corporation if the stock of that corporation was owned by the U.S. shareholders for at least 10 years before the date of the sale or exchange. a. Investment in U.S. property

Reasons for change

As indicated above, an investment in U.S. property by a controlled foreign corporation is treated as a taxable distribution to its U.S. shareholders. The reason why this provision was adopted was the belief that the use of untaxed earnings of a controlled foreign corporation to invest in U.S. property was "substantially the equivalent of a dividend" being paid to the U.S. shareholders. Therefore, it was concluded that this should be the occasion for the imposition of a tax on those earnings to the U.S. shareholders of the controlled foreign corporation making the U.S. investment. However, prior law was very broad as to the types of property which were to be classified as U.S. investments for purposes of this rule. For example, the acquisition by the foreign corporation of stock of a domestic corporation or obligations of a U.S. person (even though unrelated to the investor) was considered an investment in U.S. property for purposes of imposing a tax on the untaxed earnings to the investor's U.S. shareholders.

The Congress believed that the scope of the provision was too broad. In its prior form it may, in fact, have had a detrimental effect upon our balance of payments by encouraging foreign corporations to invest their profits abroad. For example, a controlled foreign corporation looking for a temporary investment for its working capital was, by this provision, induced to purchase foreign rather than U.S. obligations. In the Congress's view a provision which acts to encourage, rather than prevent, the accumulation of funds offshore should be altered to minimize any harmful balance of payments impact while not permitting the U.S. shareholders to use the earnings of controlled foreign corporations without payment of tax.

In the Congress's view, since the investment by a controlled foreign corporation in the stock or debt obligations of a related U.S. person or its domestic affiliates makes funds available for use by the U.S. shareholders, it constitutes an effective repatriation of earnings which

should be taxed. The classification of other investments in stock or debt of domestic corporations as the equivalent of dividends is, in the Congress's view, detrimental to the promotion of investments in the United States. Accordingly, the Act provides that an investment in U.S. property does not result when the controlled foreign corporation invests in the stock or obligations of unrelated U.S. persons.

In addition, the Congress believes that the inclusion of oil-drilling rigs used on the U.S. continental shelf acted as a disincentive to explore for oil in the United States. Since these rigs are movable, they can easily be used in a foreign country. Accordingly, the Act excludes these rigs from the definition of U.S. property.

Explanation of provision

The Act adds three exceptions to the types of U.S. property the investment in which by a controlled foreign corporation results in taxation to its U.S. shareholders (see sec. 951 (a) (1) (B)). It provides that the term "United States property" does not include stock or debt of a domestic corporation (unless the corporation is itself a U.S. shareholder of the controlled foreign corporation), if the U.S. shareholders of the controlled foreign corporation own or are considered to own, in the aggregate, less than 25 percent of the total combined voting power of all classes of stock of such domestic corporation which are entitled to vote. Thus, under this provision, a controlled foreign corporation cannot buy the stock of, or lend money to, any of its U.S. shareholders. In addition, a controlled foreign corporation cannot buy the stock of, or lend money to, U.S. corporations who are not U.S. shareholders of that controlled foreign corporation if those U.S. shareholders own 25 percent or more of the stock of the U.S. corporation. This 25 percent test is to be applied immediately after the investment by the controlled foreign corporation.

For purposes of determining who is a U.S. shareholder of a controlled foreign corporation, the constructive ownership rules apply (sec. 958(b)). However, the exception to those rules for certain persons other than U.S. persons (contained in sec. 958 (b) (1) and (4)) do not apply. Thus, for example, stock owned by foreign persons is attributed to U.S. persons for purposes of determining whether U.S. shareholders of the controlled foreign corporation own 25 percent or more of a domestic corporation, the stock of which is acquired by the controlled foreign corporation, in determining whether there has been an investment in U.S. property. If at any time there is an investment in U.S. property, the U.S. shareholders of the controlled foreign corporation will be treated as having received a distribution under section 956 equal to the amount of the investment of the controlled foreign corporation. It is intended that if the facts indicate that the controlled foreign subsidiary facilitated a loan to, or borrowing bv, a U.S. shareholder, the controlled foreign corporation is considered to have made a loan to (or acquired an obligation of) the U.S. shareholder (sec. 956 (c)).

The Act also excludes from the definition of U.S. property movable drilling rigs (other than a vessel or aircraft) and other oil and gas exploration and exploitation equipment, including barges which are used for oil exploration and exploitation activities on the continental shelf of the United States. Basically, this exception includes that prop

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erty which is entitled to the investment credit if used outside the United States in certain geographical areas of the Western Hemisphere (see sec. 48 (a) (2) (B) (x)). For this purpose, the definition of continental shelf as used in section 638 is to be applied.

Effective dates

The amendments relating to investment in U.S. property by a controlled foreign corporation apply to taxable years of foreign corporations beginning after December 31, 1975, and to taxable years of U.S. shareholders within which, or with which, such taxable years of such foreign corporations end.

For purposes of determining the increase in investment in U.S. property for years after 1975, the cumulative amount invested in U.S. property as of the close of the last taxable year of a corporation beginning before January 1, 1976, is computed under the amendments made by this section. Consequently, in determining the increase in earnings invested in U.S. property (under sec. 951 (a) (1) (B)) in years beginning after December 31, 1975, only the investment in U.S. property as defined in the Act as of the close of the last taxable year beginning before 1976 is considered."

Revenue effect

It is estimated that this provision will have little or no effect on tax liabilities.

b. Exception for investments in less-developed countries

Reasons for change

As indicated above, prior law contained an exception to the rules providing for dividend treatment on the sale of stock of a subsidiary which is classified as a less-developed country corporation. The extent to which this exception provided an incentive to invest in lessdeveloped countries is questionable. The size of the tax benefit to the U.S. investor depended on a variety of factors, such as the foreign tax rate in the country where the investment is made and in other countries, and the capital gains tax rate in the United States. Further, the relationship of the tax benefits to the investor to the benefits obtained by the developing country was erratic since the size of the tax benefit could bear no relationship to the amount of development capital invested. While these factors might have occasionally combined to encourage investment in a certain less-developed country, the Congress believes that it would be preferable to provide whatever assistance is appropriate to less-developed countries in a direct manner where the economic costs can be accurately measured.

Explanation of provision

The Act repeals the less-developed country exception which excludes earnings accumulated while a corporation was a less-developed country corporation from those earnings and profits which are subject to tax as a dividend if there is gain from the sale or exchange of stock

2 For example. if for the last taxable year before this Act applies a controlled foreign corporation is considered to have $100 invested in U.S. property under the law in effect prior to the amendment and $75 invested in U.S. property under the law as amended, $75 is the amount considered as invested in U.S. property for purposes of determining whether there has been an increase in investment in the following year.

in the controlled foreign corporation (sec. 1248 (d) (3) of the Code). However, the exclusion is still applicable with respect to those earnings of a controlled foreign corporation which were accumulated during any taxable year beginning before January 1, 1976, while the corporation was a less-developed country corporation (as defined in sec. 902 (d) as in effect prior to the enactment of this Act). The exclusion applies to pre-1976 earnings regardless of whether the U.S. shareholder owned the stock for ten years as of that date.

Effective date

The provision repealing the less-developed country exception under section 1248 applies to taxable years beginning after December 31,

1975.

Revenue effect

It is estimated that this provision will result in an increase in budget receipts of $14 million in fiscal year 1977 and of $10 million thereafter.

c. Exclusion from subpart F of certain earnings of insurance companies

Reasons for change

As indicated above, one of the principal categories of tax haven income subject to current taxation is foreign personal holding company income (sec. 954 (c)). This item of tax haven income consists of passive investment income such as dividends, interests, rents and royalties. Prior law provided an exception for income of a foreign insurance company from its investment of unearned premiums or reserves which are ordinary and necessary for the proper conduct of its business.

In order to write insurance and accept reinsurance premiums, foreign insurance companies may be required by the laws of various jurisdictions in which they operate to meet various solvency requirements in addition to specified capital and legal reserve requirements. Many jurisdictions also employ an internal rule-of-thumb as to what the ratio of surplus to earned premiums should be. In the United States, the National Association of Insurance Commissioners employs a ratio of 1 to 3 (surplus to earned premiums) as the guideline by which State regulatory agencies can measure the adequate solvency of companies insuring casualty risks. If such a company's ratio were less than 1 to 3, for instance 1 to 4, the State regulatory agency may question its ability to accept additional risks. Surplus maintained in compliance with the 1 to 3 ratio, although not necessarily required by law, has been considered as ordinary and necessary to the proper conduct of a casualty insurance business in the United States.

Similar ratios often are employed in some foreign jurisdictions with respect to companies insuring casualty risks. Even where the foreign jurisdiction does not impose requirements as severe as those required in the United States, a foreign insurance company participating in a reinsurance pool composed princinally of companies doing business in the United States must, for all practical purposes, maintain this ratio to satisfy the State insurance authorities involved. In these situations, the State regulatory agency, emploving the relatively high ratio, will review the solvency of the foreign insurer before allowing