Temporary regs expand application of Sec. 956 anti-avoidance rule to partnerships
Temporary regs expand application of Sec. 956 anti-avoidance rule to partnerships
T.D. 9733, 09/01/2015; Reg. § 1.954-2T, Reg. § 1.956-1T, Reg. § 1.954-2, Reg. § 1.956-1
IRS has issued temporary regs that, by expanding the anti-avoidance rule in Reg. § 1.956-1T(b)(4), treat property indirectly held by a controlled foreign corporation (CFC) in connection with certain transactions involving partnerships as “U.S. property.” The temporary regs also provide guidance on when a CFC is considered to derive rents and royalties in the active conduct of a trade or business for purposes of determining foreign personal holding company income (FPHCI).IRS also made a number of changes to final regs to coordinate the application of the temporary regs.
For contemporaneously issued proposed regs under Code Sec. 954 and Code Sec. 956, see ¶ 21.
Background. In general, U.S. shareholders of a foreign corporation are not subject to U.S. taxation on the income of the foreign corporation until an actual dividend is remitted by the foreign corporation to the U.S. shareholders.However, different rules apply to U.S. shareholders of a CFC.
A CFC is defined in Code Sec. 957(a) as any foreign corporation if more than 50% of the total combined voting power of all classes of stock entitled to vote, or more than 50% of the total value of the stock of the corporation, is owned directly, indirectly, or constructively by U.S. shareholders on any day during the tax year of the foreign corporation. A U.S. shareholder, in turn, is any U.S. person who owns, directly, indirectly, or constructively 10% of more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation.(Code Sec. 951(b)
The U.S. shareholders of a CFC must generally include in gross income, among other things, their pro rata share of the CFC’s subpart F income and the increase during the tax year in earnings of the CFC invested in U.S. property (to the extent not included as Subpart F income).(Code Sec. 951)
- …Subpart F income. Subpart F income generally consists of certain types of passive income, one category of which is foreign base company income (FBCI). FBCI is defined by Code Sec. 954 as income earned by a CFC that is taken into account in computing the amount that a U.S. shareholder of the CFC must include in income under Code Sec. 951(a)(1)(A). FBCI includes foreign personal holding company income (FPHCI), as defined in Code Sec. 954(c), which, in turn, generally includes rents and royalties. (Code Sec. 954(c)(1)(A)) However, rents and royalties areexcludedfrom FPHCI under the “active rents and royalties exception” if they are received from a person other than a related person and derived in the active conduct of a trade or business within the meaning of Code Sec. 954(c)(2)(A) and Reg. § 1.954-2 .
- …Investments in U.S. property. A U.S. shareholder of a CFC includes in income a pro rata amount based on the CFC’s investments in U.S. property, whether held directly or indirectly. (Code Sec. 956) “U.S. property” includes, among other things, tangible property located in the U.S., stock of a domestic corporation, and certain obligations of U.S. persons. (Code Sec. 956(c)) An indirect investment would include, for example, property held on a CFC’s behalf by a trust or nominee.
IRS has express authority under Code Sec. 956(e) to issue regs necessary to carry out the purposes of Code Sec. 956, including to prevent the avoidance of that section (i.e., to avoid current income inclusion for U.S. shareholders).To this end, under Reg. § 1.956-1T(b)(4) (the “anti-avoidance rule”), at the District Director’s discretion, a CFC will be considered to indirectly hold investments in U.S. property acquired by any other foreign corporation that is controlled by the CFC if one of the principal purposes for creating, organizing, or funding (through capital contributions or debt) such other foreign corporation is to avoid the application of Code Sec. 956 with respect to the CFC.
New guidance.IRS has issued temporary regs, described below, treating certain property held by a CFC in connection with certain transactions involving partnerships as “U.S. property” and providing guidance on the active rents and royalties exception.
…Modification of anti-avoidance rule. The temporary regs modify the existing anti-avoidance rule by:
- i. Broadening the reach of the anti-avoidance rule so that it can also apply when a foreign corporation controlled by a CFC is funded other than through capital contributions or debt. (Reg. § 1.956-1T(b)(4)(iv))
- ii. Making the rule self-executing—i.e., so that it applies without requiring IRS to exercise its discretion.
- iii. Expanding the rule to include transactions involving partnerships that are controlled by the CFC (as opposed to just foreign corporations that are controlled by the CFC). (Reg. § 1.956-1T(b)(4)(i)(C)) IRS noted in T.D. 9733 that partnerships can potentially be used to structure transactions similar to those covered by the existing anti-avoidance rule.
The rules described above apply to tax years of CFCs ending on or after Sept. 1, 2015, and to tax years of U.S. shareholders in which or with which such tax years end, with respect to property acquired, including property treated as acquired as the result of a deemed exchange of property pursuant to Code Sec. 1001, on or after Sept. 1, 2015.(Reg. § 1.956-1T(g)(1))
…New rule—foreign partnership distributions funded by CFCs. IRS has become aware that CFCs are engaging in transactions in which (i) a CFC lends funds to a foreign partnership, which then distributes the proceeds from the borrowing to a U.S. partner who is related to the CFC and whose obligation would be U.S. property if it were held (or treated as held) by the CFC; or (ii) the CFC guarantees a loan to a foreign partnership, which then distributes the loan proceeds to a related U.S. partner. Taxpayers take the position that Code Sec. 956 does not apply to these transactions even though the CFC’s earnings are effectively repatriated to a related U.S. partner.
In response, IRS has added Reg. § 1.956-1T(b)(5), which, for Code Sec. 956 purposes, treats the partnership obligation as an obligation of the distributee partner (and thus as U.S. property) to the extent of the lesser of (i) the amount of the distribution that would not have been made but for the funding of the partnership, or (ii) the amount of the foreign partnership obligation.
The rules described above apply to tax years of CFCs ending on or after Sept. 1, 2015, and to tax years of U.S. shareholders in which or with which such tax years end, in the case of distributions made on or after Sept. 1, 2015. (Reg. § 1.956-1T(g)(2))
…Active rents and royalties exception modified and clarified. The existing regs under Code Sec. 954 provide the exclusive rules for determining whether rents and royalties are derived in the active conduct of a trade or business for purposes of the exception. Two ways for rents and royalties to be so treated are by satisfying the “active development test,” which requires the CFC to be regularly engaged in the manufacture, production, development, etc. of property, and the “active marketing test,” which requires the CFC to operate in a foreign country an organization that is regularly engaged in the business of marketing, or marketing and servicing the leased or licensed property, and that is “substantial” in relation to the rents and royalties derived from the leased or licensed property (which a safe harbor provides is 25% or more). (Reg. § 1.954-2)
The active rents and royalties exception is to distinguish between a CFC that passively receives investment income and a CFC that derives income from the active conduct of a trade or business.So, consistent with the policy underlying this distinction, the temporary regs expressly provide that the CFC lessor or licensor must perform the required functions through its own officers or staff of employees for the exception to apply. (Reg. § 1.954-2T(c)(1)(i), Reg. § 1.954-2T(d)(1)(i))
IRS has also concluded consistent with this policy that the relevant activities undertaken by a CFC through its officers or employees can be performed in more than one foreign country, and updated Reg. § 1.954-2T(c)(1)(iv), Reg. § 1.954-2T(c)(2)(ii) , Reg. § 1.954-2T(d)(1)(ii), and Reg. § 1.954-2T(d)(2)(ii) accordingly.
The new temporary regs also provide that, in applying the active development and active marketing tests, CST and PCT payments (for cost sharing transactions and platform contribution transactions, respectively) made by a CFC pursuant to cost sharing arrangements (i.e., where a person other than the CFC actually conducts the relevant activities) won’t cause the CFC’s officers and employees to be treated as undertaking these activities. (Reg. § 1.954-2T(c)(2)(viii), Reg. § 1.954-2T(d)(2)(v) ) In addition, deductions for these payments are excluded from the definition of active leasing and licensing expenses and don’t count for purposes of determining whether an organization is “substantial” under the safe harbor described above. (Reg. § 1.954-2T(c)(2)(iii)(E), Reg. § 1.954-2T(d)(2)(iii)(E))
The active development test rules described above apply to rents or royalties received or accrued during tax years of CFCs ending on or after Sept. 1, 2015, and to tax years of U.S. shareholders in which or with which such tax years end, but only with respect to property manufactured, produced, developed, or created, or, in the case of acquired property, property to which substantial value has been added, on or after Sept. 1, 2015. The active marketing test rules described above, as well as the rules regarding cost-sharing agreements, apply to rents or royalties received or accrued during tax years of CFCs ending on or after Sept. 1, 2015, and to tax years of U.S. shareholders in which or with which such tax years end, to the extent that such rents or royalties that are received or accrued on or after Sept. 1, 2015. (Reg. § 1.954-2T(j))
Effect on final regs. The final regs add cross-references (in general, indicating “[Reserved],” referring readers to the parallel temporary reg cite for further guidance) to coordinate the application of the temporary regs.
References: For CFC’s investment in U.S. property taxed to its U.S. shareholders, see FTC 2d/FIN ¶ O-2760; United States Tax Reporter ¶ 9564; TG ¶ 30426. For subpart F income, see FTC 2d/FIN ¶ O-2470; United States Tax Reporter ¶ 9524 ; TG ¶ 30425.