The Truth About Grantor Trusts and Subpart F Income

Tax court ruling in Textron case could affect U.S. companies with cross-border holdings.
Robert WillensOctober 4, 2001

Where a foreign corporation is classified as a ”Controlled Foreign Corporation” (CFC), because more than 50 percent of its stock is owned by U.S. shareholders (U.S. persons who own at least 10 percent of the voting power of the foreign corporationís outstanding stock), such U.S. shareholders must include in their gross income their pro-rata share of the CFC’s Subpart F income. Such Subpart F income must be so included whether or not it is actually repatriated to the U.S. shareholder.

In Textron, Inc. v. Commissioner, for example, Textron acquired substantially all of the stock of a foreign corporation; a U.K. company named Avdel, PLC. Due to concerns regarding restraint of trade, however, the FTC immediately filed a complaint and a court issued, with respect to this acquisition, a temporary restraining order which matured into an injunction. Textron was enjoined from exercising control with respect to Avdel; all rights to exercise voting power would, instead, be vested in a trustee. Textron and such trustee entered into a voting trust agreement and, in connection with such agreement, Textron was entitled to payments equal to the amount of any cash dividends distributed by Avdel if such trustee believed that such dividend payments would be prudent. During the term of the voting trust agreement, though, Avdel earned Subpart F income. The issue was whether Textron was required to include such Subpart F income in its gross income for U.S. tax purposes. The tax court, in a circuitous way, concluded that Textron should include such Subpart F income.

Initially, the court concluded that Textron was not a U.S. shareholder subject to inclusion of Subpart F income under Sec. 951(a). That section, according to the court, only applies to a taxpayer who owns stock in a foreign corporation on the last day in the year on which such foreign corporation is a CFC. For this purpose, however, a taxpayer owns stock only if such stock is directly owned or is indirectly owned through one or more foreign entities. Here, Textron did not directly own Avdelís stock.

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Instead, the voting trust was the direct owner of such stock. The court rejected the I.R.S.ís claim that constructive ownership (Textron constructively owned, under the rules of Sec. 318, the stock owned by the trust) satisfies the ownership requirement ingrained in Sec. 951(a). Those rules are expressly incorporated in Sec. 951(b), the provision that defines the term U.S. shareholder, but are excluded from Sec. 951(a) — the operative provision that tells us whether such a U.S. shareholder is subject to inclusion of Subpart F income.

While Textron won the Sec. 951(a) battle, it ultimately lost the war. The court went on to conclude that the trust was a U.S. shareholder (it was a U.S. person that directly owned more than 10 percent of the stock of Avdel, a CFC). Therefore, the trust must include the CFC’s Subpart F income in its gross income. This trust was found to be a grantor trust, however, of which Textron is considered to be the owner. As a result, Textron must include in its gross income the trust’s Subpart F income. The trust was a grantor trust because the grantor (Textron) had powers, in respect of the trust property, that were tantamount to ”dominion and control” over such property.

Crucially, with respect to the finding that the trust was such a grantor trust, Textron was entitled to the income of the trust without the approval of an ”adverse party” (the trustee was not such an adverse party because the trustee did not have a beneficial interest in the trust). The fact that Textron was entitled to payments equal to the amount of any cash dividends distributed by Avdel was the key to the conclusion that the trust was a grantor trust. Since Textron was considered the owner of such trust it followed that Textron was compelled to include in its gross income the trust’s Subpart F income.

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