Preamble to Prop Reg REG-114540-18, Prop Reg 1.956-1, IR 2018-210, 10/31/2018
Amount Determined Under Section 956 for Corporate U.S. Shareholders
IRS has issued proposed regs that would reduce the amount determined under Code Sec. 956 for certain domestic corporations that own (or are treated as owning) stock in foreign corporations. Under the proposed regs, neither an actual dividend to a corporate U.S. shareholder, nor such a shareholder’s amount determined under Code Sec. 956, will result in additional U.S. tax.
Background. Under Code Sec. 957, a controlled foreign corporation (CFC) is a foreign corporation with regard to which more than 50% of the total combined voting power of all classes of stock entitled to vote or of the total value of the stock of the corporation is owned (directly, indirectly, or constructively) by U.S. shareholders. A U.S. shareholder for CFC purposes is a U.S. person who owns 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation, or 10% or more of the total value of shares of all classes of stock of such foreign corporation. (Code Sec. 951(b))
Code Sec. 951(a)(1)(B) requires a U.S. shareholder of a CFC to include in gross income the amount determined under Code Sec. 956 (the “section 956 amount”) with respect to the CFC to the extent not excluded from gross income under Code Sec. 959(a)(2) (the inclusion, a “section 956 inclusion”). A U.S. shareholder’s section 956 amount with respect to a CFC for a tax year is the lesser of (1) the excess (if any) of such shareholder’s pro rata share of the average of the amounts of U.S. property held (directly or indirectly) by the CFC as of the close of each quarter of such tax year, over the amount of earnings and profits described in Code Sec. 959(c)(1)(A) with respect to such shareholder, or (2) such shareholder’s pro rata share of the applicable earnings of the CFC. Applicable earnings are defined as the sum of accumulated earnings and profits (not including deficits) described in Code Sec. 316(a)(1) and current earnings and profits described in Code Sec. 316(a)(2), reduced by distributions made during the year and earnings and profits described in Code Sec. 959(c)(1). Under Code Sec. 956(c), U.S property includes tangible property located in the U.S., stock of a domestic corporation, an obligation of a U.S. person, and any right to use in the U.S. certain intangible property.
The Tax Cuts and Jobs Act (TCJA, P.L. 115-97, 12/22/2017) established a participation exemption system for the taxation of certain foreign income. Under Code Sec. 245A(a), as added by TCJA, in the case of any dividend received from a specified 10% owned foreign corporation by a domestic corporation which is a U.S. shareholder with respect to such foreign corporation, there is allowed as a deduction an amount equal to the foreign-source portion of such dividend. A specified 10% owned foreign corporation is defined in Code Sec. 245A(b) as any foreign corporation (other than certain passive foreign investment companies) with respect to which a domestic corporation is a U.S. shareholder.
Under Code Sec. 246(c)(1) and Code Sec. 246(c)(5), a domestic corporation that is a U.S. shareholder is not allowed a Code Sec. 245A deduction in respect of any dividend on any share of stock of a specified 10% owned foreign corporation that the domestic corporation holds for 365 days or less during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to the dividend. Under Code Sec. 246(c)(1)(B), a Code Sec. 245A deduction is also not allowed to the extent the domestic corporation is under an obligation to make related payments with respect to positions in substantially similar or related property.
IRS has determined that as a result of the enactment of the participation exemption system under the TCJA, the current broad application of Code Sec. 956 to corporate U.S. shareholders would be inconsistent with the purposes of Code Sec. 956 and the scope of transactions it is intended to address.
The purpose of Code Sec. 956 is generally to create symmetry between the taxation of actual repatriations and the taxation of effective repatriations, by subjecting effective repatriations to tax in the same manner as actual repatriations. However, under the participation exemption system, earnings of a CFC that are repatriated to a corporate U.S. shareholder as a dividend are typically effectively exempt from tax because the shareholder is generally afforded an equal and offsetting dividends received deduction under Code Sec. 245A. A section 956 inclusion of a corporate U.S. shareholder, on the other hand, is not eligible for the dividends received deduction under Code Sec. 245A (because it is not a dividend). As a result, the application of Code Sec. 956 after the TCJA to corporate U.S. shareholders of CFCs that would qualify for Code Sec. 245A deductions would result in disparate treatment of actual dividends and amounts “substantially the equivalent of a dividend” — a result directly at odds with the manifest purpose of Code Sec. 956.
Proposed regs. The proposed regs exclude corporate U.S. shareholders from the application of Code Sec. 956 to the extent necessary to maintain symmetry between the taxation of actual repatriations and the taxation of effective repatriations. In general, under Code Sec. 245A and the proposed regs, respectively, neither an actual dividend to a corporate U.S. shareholder, nor such a shareholder’s amount determined under Code Sec. 956, will result in additional U.S. tax.
To achieve this result, the proposed regs provide that the amount otherwise determined under Code Sec. 956 with respect to a U.S. shareholder for a tax year of a CFC is reduced to the extent that the U.S. shareholder would be allowed a deduction under Code Sec. 245A if the U.S. shareholder had received a distribution from the CFC in an amount equal to the amount otherwise determined under Code Sec. 956.
The proposed regs provide special rules with respect to indirect ownership. Due to the broad applicability of Code Sec. 245A, in many cases a corporate U.S. shareholder will not have a section 956 inclusion as a result of a CFC holding U.S. property under the proposed regs.
IRS notes that Code Sec. 956 will continue to apply without modification to U.S. shareholders other than corporate U.S. shareholders, such as individuals, to ensure that, consistent with the purposes of Code Sec. 956, amounts that are substantially the equivalent of a dividend will be treated similarly to actual dividends. This treatment will apply to individuals regardless of whether they make an election under Code Sec. 962 (under which an individual elects to be taxed on his Code Sec. 951(a) inclusions at lower corporate tax rates). Because individuals are not eligible for a dividends received deduction under Code Sec. 245A even if they make an election under Code Sec. 962, the current application of Code Sec. 956 to individuals is still necessary to ensure substantial equivalence between an actual repatriation and a deemed repatriation.
Similarly, Code Sec. 956 will continue to apply without reduction to regulated investment companies (RICs) and real estate investment trusts (REITs) because they are not allowed the dividends received deduction under Code Sec. 245A. See Code Sec. 852(b)(2)(C) and Code Sec. 857(b)(2)(A).
IRS states that the proposed regs would significantly reduce complexity, costs, and compliance burdens for corporate U.S. shareholders of CFCs.
Other changes. The proposed regs also add, in Prop Reg § 1.956-1(g)(5), the effective date for Prop Reg § 1.956-1(e)(6) that was inadvertently deleted in TD 9792 (see “Final CFC regs include rules on what constitutes U.S. property”). In addition, IRS indicated it intends to make conforming amendments to the examples throughout the regs under Code Sec. 956 upon finalization of the proposed regs.
Applicability date. The proposed regs are proposed to apply to tax years of a CFC beginning on or after the date of publication as final regs in the Federal Register, and to tax years of a U.S. shareholder in which or with which such tax years of the CFC end.
With respect to tax years of a CFC beginning before this date, a taxpayer may rely on the proposed regs for tax years of a CFC beginning after Dec. 31, 2017, and for tax years of a U.S. shareholder in which or with which such tax years of the CFC end, provided that the taxpayer and U.S. persons that are related to the taxpayer consistently apply the proposed regs with respect to all CFCs in which they are U.S. shareholders.
References: For taxation of U.S. shareholders of CFCs, see FTC 2d/FIN ¶O-2400; United States Tax Reporter ¶9514.