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Final REGs Address Foreign Corporation DRD and Exception to Subpart F Income Rules

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

The IRS has issued final regs under Code Sec. 245A that limit the deduction for certain dividends received from foreign corporations. The final regs also address the exception to subpart F income under Code Sec. 954(c)(6) for certain dividends received by controlled foreign corporations (CFCs).

Background.

Code Sec. 245A generally allows a domestic corporation a 100-percent dividends received deduction (DRD) (the “section 245A deduction”) for the foreign-source portion of a dividend received after December 31, 2017, from a specified 10 percent-owned foreign corporation (an “SFC”).

Code Sec. 954(c)(6) provides that a dividend received by a CFC (as defined in Code Sec. 957) from a related CFC is not included in the recipient CFC’s income subject to current tax under Code Sec. 951(a) and Code Sec. 954(c) if certain requirements are satisfied (the “section 954(c)(6) exception”).

In 2019, the IRS issued temporary regs regarding Code Sec. 245A. The temporary regs also address the section 954(c)(6) exception. On the same day, the IRS issued proposed regs, the text of which copied the temporary regs. Together they are referred to herein as the 2019 regs. See Temporary, proposed CFC dividends received deduction regs (06/18/2019).

The 2019 regs provide that, in the case of a dividend received by a domestic corporation from an SFC, the amount of the section 245A deduction is limited to the portion of the dividend not constituting an “ineligible amount.” (Preamble to TD 9865)

In general, the ineligible amount is the sum of (i) 50% of the extraordinary disposition amount, and (ii) the extraordinary reduction amount. (Reg. §1.245A-5T(b)(2))

The extraordinary disposition amount is the portion of a dividend received by a section 245A shareholder from an SFC that is paid out of the extraordinary disposition account with respect to the section 245A shareholder.. (Reg. §1.245A-5T(c)(1))

In general, the extraordinary disposition account represents the shareholder’s pro rata share of the SFC’s “extraordinary disposition E&P,” reduced by the section 245A shareholder’s prior extraordinary disposition amounts, if any. (Reg. § 1.245A-5T(c)(3)(i)(C)(1)) Extraordinary disposition E&P is an amount equal to the earnings of an SFC arising from gain recognized by reason of one or more “extraordinary dispositions” (defined below) (Reg. § 1.245A-5T(c)(3)(i)(C))

The extraordinary reduction amound is the portion of a dividend attributable to certain E&P generated during any tax year ending after December 31, 2017, in which the domestic corporation reduces its ownership of the CFC.  (Reg. §1.245A-5T(e))

For there to be an extraordinary reduction amount, there must be an extraordinary reduction. An extraordinary reduction generally occurs when either (i) the controlling section 245A shareholder transfers more than 10% of its stock of the CFC (e.g., an extraordinary reduction occurs if the shareholder owns 90% of the stock of the CFC and it transfers stock representing more than 9% of the stock of the CFC) or (ii) there is a greater than 10% change in the controlling section 245A shareholder’s overall ownership of the CFC (e.g., if the shareholder owns 90% of the stock of the CFC and, as a result of an issuance to a foreign person, the shareholder’s ownership of the CFC is reduced such that it no longer owns at least 81% of the stock of the CFC). (Reg. §1.245A-5T(e)(2)(i)(A)) A controlling section 245A shareholder of a CFC is a section 245A shareholder of the CFC that, taking into account ownership of the CFC by certain other persons (such as related persons), owns more than 50% of the stock of the CFC. (Reg. § 1.245A-5T(i)(2))

In general, the prior extraordinary disposition amount is intended to measure the extent to which the section 245A shareholder’s extraordinary disposition account has disallowed the section 245A deduction or caused a subpart F inclusion due to prior dividends of an SFC. However, this amount also includes certain other prior dividends of an SFC to generally ensure that the extraordinary disposition account is reduced to the extent a dividend out of extraordinary disposition E&P does not give rise to a section 245A deduction under other provisions (such as under Code Sec. 245A(e) for hybrid dividends). (Preamble to TD 9909)

The 2019 regs provide that for a disposition by an SFC to be an extraordinary disposition, the disposition must (i) be of specified property (defined in Reg. §1.245A-5T(c)(3)(iv) as any property other than property that produces gross income described in Code Sec. 951A(c)(2)(A)(i)(I) through Code Sec. 951A(c)(2)(A)(i)(V)), (ii) occur during the SFC’s disqualified period (as defined in Reg. §1.245A-5T(c)(3)(iii)) and when the SFC was a CFC, (iii) be outside of the ordinary course of the SFC’s activities, and (iv) be to a related party. For these purposes, a disposition by an SFC includes certain indirect dispositions by the SFC through a partnership or other pass-through entities (including through ownership structures involving tiered pass-through entities). (Reg. §1.245A-5T(c)(3)(ii))

The 2019 regs provide a facts-and-circumstances rule for determining whether a disposition occurs outside of the ordinary course of an SFC’s activities. The temporary regs also provided a per se rule that a disposition is treated as outside of the ordinary course of an SFC’s activities if the disposition was undertaken with a principal purpose of generating E&P during the disqualified period or if the disposition was of intangible property, within the meaning of Code Sec. 367(d)(4). (Reg. §1.245A-5T(c)(3)(ii)(E))

The 2019 regs generally limit the Code Sec. 245A deduction to the extent the dividend is paid out of the extraordinary disposition account of the section 245A shareholder. For this purpose, the 2019 regs provide an ordering rule pursuant to which a dividend is considered paid out of non-extraordinary disposition E&P before it is considered paid out of the extraordinary disposition E&P account. (Prop Reg §1.245A-5(c)(2)(i))

The 2019 regs generally define non-extraordinary disposition E&P based on the section 245A shareholder’s share of the E&P of the SFC described in Code Sec. 959(c)(3) in excess of the balance in the section 245A shareholder’s extraordinary disposition account determined immediately before the distribution. (Prop Reg §1.245A-5(c)(2)(ii))

The 2019 regs measure a section 245A shareholder’s share of the E&P of an SFC described in Code Sec. 959(c)(3) based on the percentage of stock (by value) of the SFC owned, directly or indirectly, by the section 245A shareholder after the distribution and all related transactions. (Prop Reg §1.245A-5(c)(2)(ii)(A)(2))

Final regs.

The final regs adopt the 2019 regs as they relate to the section 954(c)(6) exception. With regards to the section 245A deduction, the final regs adopt the 2019 regs with the following modifications and additions:

Per se rule. The final regs provide that a disposition of certain types of intangible property defined in Code Sec. 367(d)(4) is not per se treated as an extraordinary disposition if the intangible property is transferred to a related party during the disqualified period with a reasonable expectation that such property would be sold to an unrelated customer within one year of the transfer. (Reg. §1.245A-5(c)(3)(ii)(C)(2)(i))

This rule is intended to apply primarily to routine transfers of limited intangible property rights in furtherance of transactions with unrelated customers. (Preamble to TD 9909) Accordingly, transfers of intangible property described in Code Sec. 367(d)(4)(C) or Code Sec. 367(d)(4)(F), such as trademarks and goodwill, are not eligible for this exception because, in general, these types of intangible property are not routinely transferred to unrelated customers.

Additionally, transfers of copyright rights within the meaning of Reg. §1.861-18 or intangible property described in Code Sec. 367(d)(4)(A) that qualify for the exception to the per se rule are still subject to a presumption that they occur outside the ordinary course of the transferor SFC’s activities. This presumption can be rebutted only if the taxpayer shows that the facts and circumstances clearly establish that the disposition took place in the ordinary course of the SFC’s activities. (Reg. §1.245A- 5(c)(3)(ii)(C)(2)(ii))

Measure a section 245A shareholder’s share of the E&P of an SFC. The final regs revise Prop Reg §1.245A-5(c)(2)(ii)(A)(2) to measure the section 245A shareholder’s share of E&P described in Code Sec. 959(c)(3) based on the percentage of stock of the SFC that the section 245A shareholder owns immediately before the distribution. (Reg. §1.245A-5(c)(2)(ii)(A)(2))

Prior extraordinary disposition. The final regs modify the definition of a prior extraordinary disposition amount to take into account certain income inclusions under Code Sec. 956. (Reg. §1.245A-5(c)(3)(i)(D)(1)(iv))

In addition, the final regs add a new type of prior extraordinary disposition amount for prior dividends that would have been subject to Reg. §1.245A-5(c) but failed to qualify for the section 245A deduction because they did not satisfy the requirement that the recipient domestic corporation be a US shareholder with respect to the distributing SFC. (Reg. §1.245A-5(c)(3)(i)(C))

Extraordinary disposition account. The final regs clarify that an extraordinary disposition account is maintained in the same currency as the extraordinary disposition E&P. (Reg. §1.245A-5(c)(3))

The final regs also provide that a section 245A shareholder’s extraordinary disposition account with respect to a distributing SFC is allocated between the distributing SFC and the controlled SFC in any Code Sec. 355 distribution in which E&P of the distributing SFC are decreased and the E&P of the controlled SFC are increased by reason of Reg. §1.312-10. (Reg. §1.245A-5(c)(4)(iii))

Elimination of remaining account balance after certain stock transfers. In general, the 2019 regs do not provide rules addressing the treatment of the remaining balance of a section 245A shareholder’s extraordinary disposition account with respect to an SFC when the section 245A shareholder directly or indirectly transfers all of its stock of the SFC and, following the transfer, no person is a section 245A shareholder of the SFC. (Preamble to TD 9909)

However, under the 2019 regs, if a section 245A shareholder ceased to be a section 245A shareholder with respect to a lower-tier CFC as a result of a direct or indirect transfer of stock of the lower-tier CFC by an upper-tier CFC, a special rule preserved the section 245A shareholder’s remaining balance of its extraordinary disposition account with respect to the lower-tier CFC. (Prop Reg §1.245A-5(c)(4)(iv))

Under Prop Reg §1.245A-5(c)(4)(iv), the section 245A shareholder’s extraordinary disposition account is preserved by increasing the account with respect to the upper-tier CFC by the remaining balance.

The final regs revise Prop Reg §1.245A-5(c)(4)(iv) to address the treatment of the remaining balance of a section 245A shareholder’s extraordinary disposition account with respect to an SFC when the section 245A shareholder directly or indirectly transfers all of its stock of an SFC (such section 245A shareholder, the “transferor”). (Reg. §1.245A-5(c)(4)(iv)) In cases in which no related party with respect to the transferor is a section 245A shareholder of the SFC following the transfer, the transferor’s remaining extraordinary disposition account balance is eliminated, to the extent not allocated or attributed to another extraordinary disposition account (“elimination rule”). (Reg. §1.245A-5(c)(4)(iv)(A).

In these cases, the remaining balance generally represents an individual’s or a foreign (non-CFC) person’s share of E&P of the SFC, such that, after the transfer, distributions of the E&P are unlikely to give rise to a dividend eligible for the section 245A deduction. Therefore, there is generally not a policy need to continue tracking such E&P. (Preamble to TD 9909) The elimination rule does not apply, however, if a section 245A shareholder that is a related party with respect the transferor continues to own stock of the SFC after the transfer; instead the related section 245A shareholder succeeds to the remaining account balance. (Reg. §1.245A-5(c)(4)(iv)(B))

Moreover, transactions with a principal purpose of avoiding this limitation on the application of the elimination rule are disregarded. For example, if a US individual acquires all of the stock of an SFC from a section 245A shareholder and subsequently, pursuant to a plan that included the acquisition, transfers all of the stock of the SFC to a domestic corporation that is a section 245A shareholder of the SFC, the transfer to the US individual would be disregarded. (Reg. §1.245A-5(c)(4)(vii))

The final regs add a rule that a transfer of stock of an SFC otherwise subject to Reg. §1.245A-5(c)(4)(iv)(A) is deemed to have been undertaken with a principal purpose of avoiding the purposes of the Reg. §1.245A-5(h) anti-abuse rule if stock of the SFC is transferred to a section 245A shareholder within one year after the transaction that would be subject to Reg. §1.245A-5(c)(4)(vii). (Reg. §1.245A-5(c)(4)(vii))

Extraordinary reduction. The final regs clarify that each controlling section 245A shareholder participating in the extraordinary reduction with an extraordinary reduction amount greater than zero, and each US tax resident that is a US shareholder of the CFC at the end of the day of the extraordinary reduction (thus including a person that becomes a US shareholder of the CFC by reason of the extraordinary reduction), must enter into a binding agreement to close the taxable year of the CFC. (Preamble to TD 9909)

The final regs also allow a US tax resident that owns its interest in the CFC through a partnership to delegate the authority to enter into the binding agreement on its behalf provided that the delegation is pursuant to a written partnership agreement (within the meaning of Reg. §1.704-1(b)(2)(ii)(h)). (Reg. §1.245A-5(e)(3)(i)(C)(2))

Rules added by the final regs. The final regs provide that in a transaction described in Reg. §1.1248-8(a)(1) where stock of an SFC is transferred to a foreign acquiring corporation in exchange for stock of a foreign corporation, any extraordinary disposition account with respect to the SFC remains with the pre-transaction section 245A shareholder. (Reg. §1.245A-5(c)(4)(vi)(A))

An exception to this rule applies in the case of a transaction described in Reg. §1.1248(f)-1(b)(2) or Reg. §1.1248(f)-1(b)(3). In this type of transaction, the extraordinary disposition account is transferred in the manner provided in Reg. §1.245A-5(c)(4)(i), with certain adjustments, in order generally to ensure that a section 245A shareholder succeeds to an extraordinary disposition account to the extent that, after the transaction, the section 245A shareholder would likely be able to access the E&P as to which the extraordinary disposition account relates. (Reg. §1.245A-5(c)(4)(vi)(B))

Under the final regs, other transactions described in Reg. §1.1248-8(a)(1) cause the extraordinary disposition account to be transferred to the extent and in the manner provided under the general rule of Reg. §1.245A-5(c)(4)(i).

Similarly, the final regs also provide a rule addressing transactions in which an SFC acquires the assets of another SFC in a triangular asset reorganization and the section 245A shareholder of the target SFC receives stock of a domestic corporation that controls the acquiring SFC. In these triangular reorganizations, the domestic corporation whose stock was issued in the triangular reorganization succeeds to the extraordinary disposition account of the section 245A shareholder with respect to the target SFC. (Reg. §1.245A-5(c)(4)(ii)(B))

The final regs provide a rule that treats related domestic corporations as a single domestic corporation for purposes of determining the extent to which a dividend is an extraordinary disposition amount or a tiered extraordinary disposition amount. The final regs also treat related domestic corporations as a single domestic corporation for purposes of reducing a section 245A shareholder’s extraordinary disposition account by prior extraordinary disposition amounts. (Reg. §1.245A-5(g)(7), Reg. §1.245A-5(i)(19))

The 2019 regs did not address whether a section 245A shareholder of the new target succeeds to an extraordinary disposition account with respect to the old target when an election under Code Sec. 338(g) (section 338(g) election) is made with respect to an SFC target. (Preamble to TD 9909) The IRS notes that, in general, the new target does not inherit any of the E&P of the old target (and, as a result, no distributions by the new target could represent a distribution of E&P of the old target generated in an extraordinary disposition). Therefore the final regs clarify that, in connection with a section 338(g) election, a section 245A shareholder of the new target generally does not succeed to an extraordinary disposition account with respect to the old target. (Reg. §1.245A-5(c)(4)(v)(A)) Special rules are provided for transactions in which a section 338(g) election is made and not all of the stock of the SFC target is subject to the qualified stock purchase. (Reg. §1.245A-5(c)(4)(v)(B))

Effective dates.

The final regs apply to tax periods ending on or after June 14, 2019 (the date the proposed regs were filed with the Federal Register). (Reg. §1.245A-5(k)(1))

In a case where both the temporary regs and the final regs could apply, only the final regs apply. (Reg. §1.245A-5(k)(1)) For example, if a CFC has a tax period ending on November 30, 2019, and it made a distribution during that period on December 1, 2018, a portion of which would be an ineligible amount, the final regs apply to the distribution. (Preamble to TD 9909)

Distributions made after December 31, 2017, and before the final regs apply, continue to be subject to the rules set forth in the temporary regs. (Preamble to TD 9909) However, a taxpayer may choose to apply the final regs to distributions made during this period, provided that the taxpayer and all related parties consistently apply the final regs in their entirety. (Reg. §1.245A-5(k)(2))

To continue your research on the limit on the deduction for dividends received from SFCs, see FTC 2d/FIN ¶O-2951United States Tax Reporter ¶245A4. For the the exception to subpart F income under Code Sec. 954(c)(6) for certain dividends received by CFCs, see FTC 2d/FIN ¶O-2550United States Tax Reporter ¶9544.

 

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