Following closely on the heels of the 1996 Small Business Job Protection Act ("Small Business Act"), which dramatically changed the tax treatment of foreign trusts and expatriates, the Taxpayer Relief Act of 1997 (the "Act") made significant changes to the provisions of the Internal Revenue Code governing international business. While the Act purported to simplify existing foreign tax rules, many tax practitioners remain skeptical. For example, the Act substantially increased the reporting penalties on controlled foreign corporations and imposed a new set of reporting requirements for controlled foreign partnerships. However, portions of the Act do offer significant relief to taxpayers, most notably those provisions relating to the taxation of Controlled Foreign Corporations ("CFCs") which are also Passive Foreign Investment Companies ("PFICs"). The new Foreign Sales Corporation ("FSC") licensing provisions and the transition rules preventing unintended trust migrations are also likely to benefit many taxpayers.

Passive Foreign Investment Companies
Elimination of CFC and PFIC Overlap. A CFC is a foreign corporation owned more than 50 percent (by vote or value) by U.S. shareholders. For this purpose, a U.S. shareholder is defined as a U.S. person who owns, directly or indirectly, at least 10 percent of the corporation's voting stock. If an entity is a CFC, certain categories of its income (most notably, passive investment income, such as investment gains, interest, dividends, rents and royalties) will be taxed to its U.S. shareholders as a "deemed dividend" whether or not such income is actually distributed to the U.S. shareholders. Deemed dividend treatment can also occur if a CFC makes loans to its U.S. shareholders or invests in U.S. property. Upon a sale of CFC shares, U.S. shareholders are required to treat gain realized as ordinary income to the extent of their pro rata shares of the CFC's accumulated net earnings and profits.

A foreign corporation will be a PFIC if 75% or more of its gross income is passive, or 50% or more of its assets are held for the production of passive income. U.S. persons who own PFIC shares may be taxed currently on their shares of the earnings of the PFIC, on a "flow through" basis, if they have made a Qualified Electing Fund ("QEF") election. Absent a QEF election, a U.S. shareholder will be taxed only upon receiving distributions from the PFIC, but will be subjected to a significant interest charge to the extent such distributions are attributed to earnings from prior PFIC years. Generally, the portion of the distribution in excess of a regular annual dividend is allocated ratably over the U.S. taxpayers holding period of the shares, and the taxpayer is responsible for tax as if such allocated portion actually had been earned by the taxpayer in those years. Interest is charged at the IRS underpayment rate from the year of the allocation to the year of the distribution.

Since a foreign corporation can be both a PFIC and a CFC, U.S. persons owning 10% or more of the voting shares of such an entity historically have been subject to both tax regimes. The most important consequence of this overlap was that foreign corporations engaged in an offshore active business could be thrown unexpectedly into PFIC status (for example if the passive asset threshold of such corporations exceeded 50%) resulting in a substantial PFIC interest charge when distributions were paid to U.S. shareholders. The Act eliminates the CFC/PFIC overlap for U.S. shareholders of CFCs. For CFCs which have never been PFICs, the new law provides that U.S. shareholders will continue to be taxed under the CFC regime and not the PFIC regime, even if the corporation later becomes a PFIC. If a CFC was also a PFIC at some time prior to January 1, 1998, and no QEF election was in place covering its entire PFIC period, U.S. shareholders will continue to be subject at least in part to both tax regimes unless they make a one-time election to pay tax and the PFIC interest charge with respect to either the gain inherent in their shares or their portion of the cumulative earnings of the corporation.

New "Mark-to-Market" Election. Effective for taxable years beginning after December 31, 1997, a U.S. person who owns marketable PFIC stock may elect to treat his or her shares as sold as of the last day of the U.S. person's tax year. In years for which such a mark-to-market election is in effect, the rules applicable to non-qualified funds (i.e. non-QEF PFICs) do not apply to a shareholder. U.S. persons can thereby avoid the PFIC interest charge upon the receipt of dividends or upon the sale of PFIC shares, even if they lack sufficient financial information to make a QEF election.

A shareholder who makes the new "Mark to Market" election will recognize ordinary income to the extent the fair market value of the stock exceeds its basis at the end of the shareholder's taxable year. Such deemed gains will not be eligible for capital gains treatment. Deemed losses will only be available to the extent of prior deemed gains.

Valuation of Assets. For purposes of determining the proportion of assets held for the production of passive income, the assets of a non-publicly traded PFIC which is also a CFC are valued using the adjusted basis instead of their fair market value. Non-publicly traded PFICs that are not CFCs must generally value assets at market, but are permitted to elect to use the adjusted basis valuation method. The Act sets forth the new rule that publicly traded PFICs will measure assets at market.

Transfers to Foreign Trusts and Partnerships
The Act repealed Sections 1491 through 1494 of the Internal Revenue Code which had imposed a 35% excise tax on gain inherent in property transferred by U.S. persons to foreign trusts and partnerships. In their place, the Act installed new Section 684, requiring the recognition of gain on transfers of appreciated property to foreign trusts (other than grantor trusts) or foreign estates, and Section 721(c) which requires recognition of gain on U.S. contributions of property to foreign partnerships.

Information Reporting
Controlled Foreign Entities. For tax years beginning after August 5, 1997, the Act requires reports from certain U.S. partners of Controlled Foreign Partnerships ("CFPs"), similar to those that have long been required of the U.S. shareholders of CFCs. For these purposes, a CFP is a foreign partnership more than 50% of the capital or profits interest of which is owned by "10-percent partners". A 10-percent partner is a U.S. person who owns more than a 10% capital or profits interest in the partnership directly or by attribution.

Recently proposed IRS regulations would require 10-percent partners to file IRS Form 8865, disclosing the CFO's financial status and would require any U.S. person who owns at least 50-percent (directly or by attribution) of a CFP to disclose on Form 8865 the names of other 10-percent partners. Effective for changes in partnership interests occurring after 1997, the proposed regulations would also require a U.S. partner (or deemed partner by attribution) to file a Form 8865 to report major changes in percentage ownership in the foreign partnership including the acquisition or disposition of a 10-percent or greater partnership interest.

Penalties Increase Ten-fold. Under prior law, a U.S. person required to file an information return with respect to a Controlled Foreign Corporation faced a penalty of $1,000 for failing to file for a given fiscal year. If such a failure to file continued for a period of 90 days after notice by the IRS, an additional penalty of $1,000 was assessed for each 30 day period such failure continued. For tax years beginning after August 5, 1997, both penalties (which now apply with respect to CFCs and CFPs) have been increased to $10,000.

Foreign Sales Corporations
The Internal Revenue Code rewards U.S. exporters who make sales abroad using a Foreign Sales Corporation ("FSC") formed in a qualified offshore jurisdiction. Such FSC's can act as resellers of goods manufactured or produced in the U.S., but are more often formed as sales commission agents for U.S. manufacturers or producers. Some of the FSC's income from the sale, lease or exchange of "qualified export property" is exempt from U. S. corporate tax, thereby reducing the overall effective tax rate on income earned from exports. Under prior law, copyrights to computer software could not qualify as export property if the software was licensed for reproduction abroad. The Act has expanded the benefits of FSC'S by allowing FSC benefits for sales and licenses of software which grant the purchaser or licensee the right to reproduce the software outside the U.S.

Foreign Tax Credit
Source of Deemed Royalties. Under prior law, deemed royalties realized upon a transfer of an intangible by a U.S. person to a foreign corporation were automatically considered U.S. source income. Now, such royalty income generally will be sourced to the country where the intangible is being used.

Deemed Paid Credit. A U.S. corporation that owns 10% or more of the voting stock of a foreign corporation is entitled to credit its proportionate share of foreign taxes paid by the foreign corporation in the year that the U. S. corporation is taxed on its share of the foreign corporation's earnings and profits. Prior to the Act, this credit was allowed only for taxes paid by first, second and third tier foreign subsidiaries of a U.S. corporation provided the foreign subsidiaries were connected by the required degree of ownership. The Act extends this indirect foreign tax credit for taxes paid by fourth, fifth and sixth tier foreign subsidiaries, where subsidiaries in the fourth, fifth and sixth tiers are controlled foreign corporations with respect to the U.S. parent.

Translation of Foreign Taxes. The Act attempts to simplify the translation of income taxes for purposes of determining the foreign tax credit. Under prior law, an accrual basis taxpayer translated the amount of foreign taxes to U.S. dollars at the spot exchange rate in effect at the close of the taxable year. If the exchange rate differed at the time when U.S. taxes were actually paid, a redetermination of the foreign tax credit was necessary. The Act now requires accrual basis taxpayers to translate foreign taxes into U.S. dollars at the average exchange rate for the tax year to which the taxes relate. No redetermination will be required unless the U.S. taxes are paid more than two years after the year to which the taxes relate or are paid in a year prior to the year to which such taxes relate.

Trust Residency
Modification of Two-Part Residency Test. The Small Business Act created an objective, two-part test to determine the tax residency of trusts. Under this test, a trust was considered a U.S. trust only if one or more U.S. trustees had authority to control all substantive decisions concerning the trust and a U.S. court could exercise primary jurisdiction over the trust. The Act has changed this rule by providing that a trust is now to be a U.S. trust so long as one or more U.S. persons (trustees or not) have authority to control all substantive decisions concerning the trust and a U.S. court can exercise primary jurisdiction over the trust. Under this amended rule, a trust can be considered foreign even though trustees are U.S. persons if substantial decision making authority is vested in a non-U.S. beneficiary or trust protector.

Transition Rule. The new trust residency rule, as modified by the Act, created the possibility that a trust classified as U.S. Trust under prior law could unintentionally become a foreign trust. Since a trust migration triggers a tax on any appreciation inherent in trust assets, this could be a tax disaster. To avoid this unintended result, the Act authorized regulatory relief in two circumstances. First, a trust in existence on August 20, 1996 which was treated as a U.S. person on August 19, 1996 can elect to be treated as a U.S. resident without a trust modification. Second, if a trust does not make the election discussed in the preceding sentence but is modified within a reasonable period to qualify as a U.S. person under the new rules, no trust migration will occur as long as the modification commences by the due date of the trust's 1997 tax return. Under a recently published IRS notice, such modification must be completed within two years of the due date of the 1997 tax return.

Other Changes
U.S. Offices of Non-U.S. Securities Traders. Non U.S. persons and entities are subject to tax at regular graduated tax rates on income effectively connected with a U.S. trade or business. Prior law set forth a safe harbor rule that non-U.S. persons (including foreign corporations and partnerships) who traded stocks and securities for their own account were not treated as engaged in a U.S. business as long as they did not have a U.S. principal office. Regulations set forth a ten factor trust for determining whether a U.S. principal office existed. The Act has eliminated the U.S. office rule, so that foreign persons who trade securities in the U.S. are not treated as engaged in a U.S. business even if they have a U.S. principal office. Likewise, foreign persons who are limited partners of a U.S. partnership which trades securities on its own behalf are not treated as engaged in a U.S. trade or business. By contrast, the rule treating non-U.S. persons who are dealers of securities in the U.S. as being engaged in a U.S. business remains unchanged. Such persons are therefore taxed on their dealer income from a U.S. trade or business whether or not they have a U.S. office.

Foreign Earned Income Exclusion. Section 911 of the Internal Revenue Code had allowed U.S. citizens and residents working abroad to exclude up to $70,000 of foreign services income and a housing allowance from U.S. taxable income. Under the Act, the $70,000 exclusion from income for U.S. citizens and residents working abroad increases at the rate of $2,000 per year until 2002 and is adjusted for inflation thereafter.

Situs of Certain Debt Instruments. Prior to the Act, deposits with a bank or insurance company and debt instruments that qualify for income tax exemption under the "portfolio debt" rules were not considered situated in the U.S., and therefore were excluded from the taxable estate of a Non-resident alien. The Act has extended this non U.S. situs treatment to embrace short term original issue discount obligations, interest from which is not taxable to non-resident alien individuals. Curiously, the Act continues to leave open the question of whether municipal bonds qualify for non U.S. situs treatment.

Paul M. Roy is a principal with Bergman, Horowitz & Reynolds, P.C.