Under the context of controlled foreign corporations, a U.S. shareholder is defined as a U.S. Person who owns or is considered as owning 10% or more of the total combined voting power of all classes of stock entitled to vote of a foreign corporation. Does this language mean that constructive ownership is considered when determining whether the applicable person is a 10% owner and thus a U.S. shareholder? The answer is yes! Stock that is held directly, indirectly and constructively with the meaning of Internal Revenue Code Section 958 is taken into account when determining ownership.
Because of this rule and the application of attribution rules, a U.S. shareholder of shareholders are unable to avoid U.S. shareholder status by distributing stock of a foreign corporation to related parties. For example, if Corporation 1 spread ownership equally amongst 20 other U.S. affiliates within an affiliated group, and thus each corporation would own 5% of the stock of Corporation 1, U.S. shareholder status could not be avoided for each shareholder because of the attribution rules, and each corporation would be treated as constructively owning the shares. It can also be important to remember that the attribution rules, attribute the stock on the value of the shares owned and the not the voting power. For example, assume stock was held by John in a corporation and the stock held was 10% of the votes but 25% of the value. The value would be considered as owning 25% of the stock held.
What about ownership in a foreign partnership, foreign trust or even a foreign estate? Do the controlled foreign corporation rules in Subpart F apply to these foreign “entities?” The answer would be no because a foreign entity must be a corporation to fall within the definition of a controlled foreign corporation, and therefore, Subpart F would not apply as a result of ownership by a United State person. Thus, we must ask the question, for purposes of a controlled foreign corporation, how is a corporation defined? One should reference Internal Revenue Code Section 7701(a)(3) per the regulations when determining whether or not a foreign business or entity is in fact a corporation within the definition of the code. Prior to 1997 a facts and circumstances test applied reviewing continuity of life, centralized management, limited liability and free transferability of assets whereby now, under 7701(a)(3) regulations, there are elective rules for classifying most foreign entities. These classification matters could be akin to certain options, often referred to as “check the box” regulations. For more information regarding check the box regulations, see 910 T.M.
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