Roberts & Holland LLP

a. A foreign corporation is a CFC if more than 50 percent (by vote or value) of the stock of the corporation is directly or indirectly owned by "United States shareholders." Indirect ownership may result from "constructive ownership" or "attribution" rules. These rules operate to prohibit taxpayers from transferring stock to family members or closely-held entities ("relatives"), to avoid various ownership thresholds that trigger adverse tax consequences, by treating stock owned by another as though it were actually owned by the taxpayer. They provide that stock owned directly by a foreign corporation, foreign partnership, or foreign trust is treated as actually owned by its shareholders, partners, or beneficiaries in proportion to their respective ownership interests in the entity. A "United States shareholder" is a United States person who owns (or is considered as owning by applying the attribution rules) 10 percent or more of the total combined voting power of all classes of stock entitled to vote. A United States person is a citizen or resident of the United States, a domestic partnership, a domestic corporation, and any estate or trust other than a foreign estate or trust.

b. Subpart F income includes certain insurance income and "foreign base company income," which is defined to include FPHCI, "foreign base company sales income," "foreign base company services income," "foreign base company shipping income," and "foreign base company oil related income."

c. A shareholder’s pro rata share of subpart F income is the amount that would have been distributed as a dividend with respect to the stock that the shareholder directly or indirectly owns if, on the last day of the taxable year, the CFC distributed all of its subpart F income pro rata to its shareholders. However, the subpart F income of any CFC for any taxable year cannot exceed the earnings and profits of the CFC for that taxable year.

d. If an amount would be included in the gross income of a United States shareholder under subpart F and under the rules relating to taxation of a foreign personal holding company, that amount is included in the gross income of the shareholder under subpart F only. If an amount would be included in the gross income of a United States shareholder under subpart F and under the rules relating to taxation of a passive foreign investment company, that amount is taxable only under subpart F. In other words, the subpart F rules take precedence over the FPHC rules and the PFIC rules.

e. Section 1248 provides that if a U.S. person sells or exchanges stock in a foreign corporation (or if a U.S. person receives a distribution from a foreign corporation treated as in exchange for stock); and that person owns, or is considered as owning, 10 percent or more of the voting power at any time during the five-year period ending on the date of the sale or exchange when the corporation was a CFC, then the gain recognized on the sale or exchange of the stock is included in the gross income of that person as a dividend, to the extent of E&P of the foreign corporation attributable to that stock, that was accumulated in taxable years of such foreign corporation during the period the stock sold or exchanged was held by such person while such foreign corporation was a CFC. If E&P of a foreign corporation is attributable to any amount previously included in the gross income of a United States person under subpart F, that amount is excluded in determining the amount of the section 1248 deemed dividend upon the sale or exchange of the stock.

a. Generally, a foreign corporation is a FPHC if the majority of its stock is owned by a few U.S. persons and most of its income is passive. A FPHC is any foreign corporation if at least 60 percent (50 percent after the first taxable year for which the corporation is a FPHC) of its gross income for the taxable year is FPHCI; and at any time during the taxable year more than 50 percent (by vote or value) of the stock is owned (directly or indirectly) by five or fewer individuals who are citizens or residents of the United States (a "U.S. group"). Gross income of a foreign corporation for purposes of classification as a FPHC includes income from foreign sources as well as United States sources. Again, constructive ownership rules apply for purposes of determining whether a foreign corporation is a FPHC. They provide that stock owned by a corporation, partnership, estate, or trust is considered as owned proportionately by its shareholders, partners or beneficiaries. An individual is considered as owning the stock owned by or for his family or by his partner. The family of an individual includes only his brothers and sisters (whether by the whole or half-blood), spouse, ancestors, and lineal descendants. For purposes of determining whether a U.S. person will be required to include a share of the foreign corporation’s undistributed FPHCI in its income, stock of a FPHC owned (directly or through the application of the constructive ownership rules) by a second foreign corporation which is not a FPHC or by a foreign partnership, foreign estate, or foreign trust is considered as owned proportionately by its shareholders, partners, or beneficiaries.

b. FPHCI for purposes of the FPHC regime is similar, but not identical to, FPHCI for subpart F purposes. FPHCI includes passive income items such as dividends, interest, royalties, annuities, the excess of gains over losses from the sale by a nondealer of stock and securities, rents (unless constituting 50 percent or more of gross income), and personal services income from services performed by a shareholder.

c. Each United States shareholder of a FPHC must include in its gross income, as a dividend, the amount it would have received if, on the last day of the taxable year, there had been distributed by the FPHC and received by the shareholders the undistributed FPHCI of the FPHC for the taxable year. Undistributed amounts included in income by a shareholder are treated as a reinvestment of capital, and result in an upward adjustment to the shareholder’s basis in the stock of the FPHC. Even if a foreign corporation escapes treatment under the FPHC rules, its U.S. shareholders are still subject to taxation on any income that constitutes FPHCI under the CFC/subpart F income rules.

d. The FPHC rules are relevant when a foreign corporation is also a CFC if a member of the FPHC’s U.S. group owns less than 10 percent, and therefore does not constitute a "United States shareholder" under the CFC rules. In such a case, U.S. shareholders with less than the requisite 10 percent ownership are taxed under the FPHC rules; the rest are similarly taxed under subpart F.

a. A PFIC is any foreign corporation if 75 percent or more of the gross income of such corporation for the taxable year is passive; or the average percentage of assets (by value) held by such corporation during the taxable year which produce passive income is 50 percent or more. In the case of nonpublicly traded CFC (or nonpublicly traded CFC making an election), this determination is based on the adjusted bases of the assets in lieu of their value.

b. A U.S. person owning any interest in a PFIC, no matter how small, is subject to the PFIC anti-deferral provisions applicable to the income earned by the PFIC (not just the passive income) attributed to his shares. These provisions consist of three taxing regimes that depend on whether or not the U.S. owner of the PFIC makes a QEF election or a mark to market election.

c. A U.S. shareholder of a FIC treats any gain on a sale or exchange of such stock as ordinary income to the extent of the U.S. shareholder’s ratable share of the E&P of the FIC.The seller’s ratable share of E&P includes only his or her ratable share of the accumulated E&P for the period the seller owned the stock, reduced by E&P attributable to (i) any amount previously included in the gross income of the seller as subpart F income; and generally (ii) any taxable year during which the corporation was not a FIC. This rule does not apply to the extent gain on a FIC stock sale is treated as ordinary income under section 1248. Generally, gain from the sale of FIC shares by 10 percent shareholders is treated as ordinary income under section 1248; and all other shareholders take such amounts into ordinary income under the above FIC rules. A foreign corporation that is a FIC can avoid the application of the above rule, if it elects to distribute to its shareholders 90 percent or more of its taxable income (calculated as if the FIC were a domestic corporation) and to provide certain written information to its shareholders and the IRS.

d. A tax equal to 39.6 percent is imposed on the undistributed PHCI of every PHC. Search7RH541. Undistributed PHCI is defined as the taxable income of a PHC as adjusted, less dividends paid for the taxable year. Unlike the subpart F provisions and the FPHC provisions, which require an amount to be included in the gross income of a shareholder, the PHC provisions impose a penalty tax on the corporation.

a. With regard to the application of these general rules to discretionary trusts, the IRC sections discussed below can generally be divided into three categories:

b. Each of these categories is discussed separately below.

a. To address the difficulty inherent in determining a beneficiary’s interest in a discretionary trust, sections 318(a)(3)(B) and 1563 adopt a "maximum exercise of discretion" standard under which a beneficiary’s actuarial interest in a trust is computed by assuming that the trustee of the trust will exercise the maximum discretion in favor of the beneficiary. Section 318(a)(3)(B) does not contain either of the general rules mentioned above because it concerns attribution of ownership to (rather than from) a trust.

b. Section 318(a)(3)(B) contains rules for determining a beneficiary’s actuarial interest in a trust because a beneficiary’s ownership of stock will not be attributed to the trust if, on an actuarial basis, the beneficiary has only a remote contingent interest in the trust. This maximum exercise of discretion standard is also found in attribution rules in certain Treasury Regulations. See Treas. Reg. Search7RH1.414(c)-4(b)(3)(i); Treas. Reg. Search7RH1.451-3(b)(3)(iii)(C)(3)(iii)(B) and (iv)(B) (to be superseded on finalization of proposed regulations promulgated on May 5, 1999, under section 460); Treas. Reg. Search7RH1.460-3(b)(3)(iii); Treas. Reg. Search7RH1.958-2(d)(1)(ii)(a); Treas. Reg. Search7RH25.2701-6(a)(4)(i). In some instances, use of the maximum exercise of discretion standard in these Treasury Regulations naturally results from the incorporation by reference of the attribution rules of either section 318 or section 1563 in the operative IRC section. See Search7RH414(b) and (c); Search7RH958(b).Search7RH318(a)(3)(B). It may also be of some interest to note that section 318(a)(2)(B), which provides for attribution from a trust to its beneficiaries and is discussed in the text below, as originally proposed by the House of Representatives, also incorporated the maximum exercise of discretion standard; however, this standard was deleted in conference. Compare H.R. Rep. No. 1337, 83rd Cong., 2d Sess. A97 (1954) with S. Rep. No. 1622, 83rd Cong., 2d Sess. 253 (1954) and H.R. Conf. Rep. No. 2543, 83rd Cong., 2d Sess. 34-35 (1954).) Search7RH1563(e)(3)(A). Section 1563 takes this approach one step further by providing that the actuarial interest of each beneficiary will be determined by also assuming the "maximum use of such stock to satisfy his rights as a beneficiary." Search7RH1563(e)(3)(A).

a. This rule provides that if the net assets of a trust exceed the sum of the definitely ascertainable actuarial values of interests in the trust, the total amount of such excess will be considered to be owned by each beneficiary:

b. Application of this rule may cause the sum of the beneficiaries’ percentage ownership interests in the trust to exceed 100 percent. See Notice of Proposed Rulemaking, 1983-2 C.B. 741, 744 ("The possibility exists in some instances, therefore, that the value of assets held by a trust...may be required to be attributed to more than one beneficiary in determining proportionate shares of the trust’s...assets.").

c. The Treasury Regulations illustrate the operation of this rule (and the potential for the rule to cause more than 100 percent ownership of the assets of the trust) with the following example:

a. This exception provides that "if a trust includes interests that are not actuarially ascertainable, all such interests shall be considered to be owned by foreign persons." Id.

b. Application of this exception causes a distribution that would otherwise qualify for nonrecognition of gain or loss under section 355 to be a taxable event.

a. Section 958(a)(2) provides that stock owned, directly or indirectly, by or for a foreign trust will be considered as being owned "proportionately" by its beneficiaries. The Treasury Regulations promulgated under section 958 indicate that "[t]he determination of a person’s proportionate interest in a...foreign trust...will be made on the basis of all the facts and circumstances in each case." Treas. Reg. Search7RH1.958-1(c)(2).

b. In Field Service Advice 1999-52-014, the IRS concluded that, where all of the income of a trust was to be distributed to one beneficiary during his lifetime:

a. In Steuben Securities Corp. v. Commissioner, 1 T.C. 395, 399(1943), the Tax Court held, in interpreting a predecessor of current Section 544, that the term "beneficiaries," as used in that section, referred only to "those who have a direct present interest in the shares and income in the taxable year and not those whose interest, whether vested or contingent, will or may become effective at a later time." This rule should have prevented the application of section 544(a)(1) to those beneficiaries of a discretionary trust who received no distributions from the trust during a given taxable year.

b. In Revenue Ruling 58-325, 1958-1 C.B. 212, 213, revoked by Rev. Rul. 62-155, 1962-2 C.B. 132, the IRS followed Steuben Securities in interpreting the attribution rule in section 421(d)(1)(C) (the predecessor of current section 424(d)), which contained language similar to that found in section 544(a)(1), and concluded that stock held by a trust would not be attributed to beneficiaries who could only receive distributions after the expiration of a 10-year period because "present actual enjoyment [is]the controlling factor in determining who is the beneficiary of the trust."

c. In Phinney v. Tuboscope Co., 268 F.2d 233 (5th Cir. 1959), the Fifth Circuit, in interpreting a predecessor of current section 544 for purposes of determining whether a corporation constituted a "new" corporation under the Korean Excess Profits Tax Statute (and without making any express negative reference to the Tax Court’s decision in Steuben Securities), held that the rule regarding attribution of ownership from trusts in section 544(a)(1) "does not confine itself to beneficiaries having an immediate and enforceable right." Id. at 238. Thus, the court concluded that stock held by a series of spendthrift trusts could be attributed to the trusts’ respective minor beneficiaries, who had vested interests in the trusts, even though such beneficiaries were entitled to no income from the trusts until age 21 (unless the trustee in its sole discretion elected to make a distribution) and none of the trusts could be terminated or its corpus distributed until its respective beneficiary reached age 25.

d. In Revenue Ruling 62-155, 1962-2 C.B. 132, the IRS reconsidered and revoked its position in Revenue Ruling 58-325, 1958-1 C.B. 212 (discussed above), in light of the decision in Tuboscope. The IRS concluded that "in determining stock ownership for the purposes of section 421(d)(1)(C) and section 544(a)(1) , the shares held by a trust are considered to be owned by its present or future beneficiaries in proportion to their actuarial interests." Id. at 133.

e. More recently, in Private Letter Ruling 90-24-076 (Mar. 21, 1990), the IRS addressed the manner in which the actuarial interest of a beneficiary of a discretionary trust should be calculated for purposes of section 544(a)(1), as interpreted by Revenue Ruling 62-155, 1962-2 C.B. 132. In Private Letter Ruling 90-24-076, the IRS acknowledged that, where "the trustees of the Trust have unrestricted discretion in selecting the recipients of income and principal, the Trust’s beneficiaries do not have actuarial interests in the Trust that can be computed pursuant to the guidelines contained in Rev. Rul. 62-155 and section 1.318-3(b) of the regulations." The IRS also acknowledged that "it is possible to postulate various methods to accomplish this allocation." However, the IRS chose the "facts and circumstances method" as the most appropriate method for determining the actuarial interest of a beneficiary in a discretionary trust. The IRS included the following in its non-exhaustive list of relevant facts and circumstances to be considered in determining the actuarial interest of a beneficiary in a discretionary trust:

f. Because of the existence of a pattern of distributions over a period of years, the IRS concluded that, under the facts and circumstances presented in Private Letter Ruling 90-24-076, a "methodology" based on this pattern would "most accurately reflect the beneficiaries’ proportionate interest [sic]in the Trust." Id. Thus, each beneficiary was considered as owning an income interest in the trust in the same proportion that the amount of distributions that he or she received bore to the total amount of distributions made by the trustee. Each beneficiary’s income interest could then be determined on an actuarial basis with reference to appropriate mortality tables as if the trustee were required to distribute the income to the beneficiary over the remainder of his or her life. Although this facts and circumstances standard sheds some light on the manner in which ownership may be attributed from a discretionary trust to its beneficiaries, it has been criticized due to its vague nature. Some of the questions that have been raised by commentators include:

a. In Hickman, the court considered this issue in construing the trust attribution rule in section 267(c)(1).

b. By way of contrast, in Revenue Ruling 58-325, 1958-1 C.B. 212, the IRS followed the Tax Court’s decision in Steuben Securities Corp. v. Commissioner, 1 T.C. 395 (1943), which involved the attribution rule under a predecessor of current section 544(a)(1), in interpreting the attribution rule in section 421(d)(1)(C) (the predecessor of current section 424(d)) . The IRS gave no indication in Revenue Ruling 58-325 that there was any issue concerning the interpretation of one attribution rule in light of authorities decided under another, similarly-worded attribution rule.

c. The IRS continued interpreting the attribution rule of section 421(d)(1)(C) in light of authorities construing predecessors of section 544(a)(1) when it revoked Revenue Ruling 58-325 based on the decision in Phinney v. Tuboscope, 268 F.2d 233 (5th Cir. 1959). See Rev. Rul. 62-155, 1962-2 C.B. 132. As discussed above, the decision in Tuboscope involved a predecessor of section 544(a)(1), which the Fifth Circuit interpreted in a manner contrary to the Tax Court’s interpretation of another (identically-worded) predecessor of that section in Steuben Securities.

a. Like the ABA proposal, the Senate Finance Committee proposal modified the maximum exercise of discretion standard by disregarding any power limited by an ascertainable standard relating to the health, education, support, or maintenance of the beneficiary. See id.

b. The Senate Finance Committee proposal also ameliorated the harshness of the maximum exercise of discretion standard by providing that if a beneficiary’s interest in the relevant stock held by the trust differed from the beneficiary’s interest in the trust as a whole, then attribution would be based on the beneficiary’s interest in the relevant stock. See id. at 17.

c. The Senate Finance Committee further included in its proposal a rule providing that if the beneficiaries of a discretionary trust included descendants of the grantor, then attribution would be determined as if all distributions were required to be made to the descendants per stirpes. See id. at 16. The New York State Bar Association criticized this per stirpes rule on the ground that it was ripe for abuse. See id. at 18-19.

a. The modified facts and circumstances approach will still not bring certainty to taxpayers in applying the general facts and circumstances standard in practice because, in a somewhat circular fashion, the "back-stop" rule will only apply if the beneficiary’s interest in the trust cannot be determi