Garlock: How Not To Structure A CFC

On March 2nd, we’re offering a free 1-hour CPE course titled “An Introduction to the U.S. Controlled Foreign Corporation Statute.”  You can sign up at this link:  
    

A CFC is a foreign corporation where a U.S. shareholder owns “more than” 50% of the offshore company.  After passage of the CFC statute, practitioners quickly noted the 50% ownership requirement and correctly deduced that, if a non-U.S. shareholder owned the remaining 50%, the foreign corporation could escape being a CFC.

     This was the tact taken by the taxpayer in Garlock, a case where a U.S. corporation owned a Panamanian company, formed before passage of the CFC statute.  In an attempt to prevent CFC classification, the U.S. parent recapitalized the Panamanian subsidiary with a preferred share which was callable at any time.  In addition, the foreign shareholder agreed not to exercise his ownership rights.  From the case: “The report mentioned specifically two foreign investors who had been approached and had said that they "understood the situation," and expressed the belief that one of them would "invest" in the new preferred stock when issued.”

     The above structure contains two key flaws.  The first was that the preferred could called at any time.  For the sake of argument, assume the foreign partner exercised its right to participate in management in a way that threatened the U.S. parent.  Should that happen, the U.S. company would simply call the stock to remove the threat.  The second flaw was the back-door deal between the partners.  This fact made the recapitalization a tax sham. 

     Garlock offers planners several lessons.  First of all, the attorneys advising the U.S. company correctly interpreted the statute: if a U.S. shareholder owns only 50% of the foreign company, it’s not a CFC.  However, this means that the U.S. shareholder must give up control, or at least exercise control on an equal footing with a foreign partner.  Second, backroom deals between taxpayers are never a good idea; should the Service investigate, they almost always come to light, thereby giving the IRS ample justification to shut down a transaction.