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QI alert 2019-02

QI alert 2019-02

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Proposed Regulations Released to Resolve Controlled Foreign Corporations and U.S. Shareholders Challenges under the TCJA

On October 1, 2019, the IRS published proposed regulations in the Federal Register (26 CFR Part 1) that aim to resolve certain unintended consequences caused by section 14213 of the Tax Cuts and Jobs Act, Pub. L. 115-97 (2017) (the “TCJA”). In particular, these proposed regulations seek to reverse the effects of the TCJA’s repeal of section 958(b)(4), which had previously exempted U.S. persons from being attributed ownership of foreign corporations through downward attribution (defined below). The repeal of section 958(b)(4) unintentionally converted a number of U.S. taxpayers into U.S. shareholders of foreign corporations and consequently caused those foreign corporations to be considered Controlled Foreign Corporations (CFCs) for U.S. tax purposes.

The newly proposed regulations seek to reverse the effect of repealing section 958(b)(4) and return these ‘accidental’ CFCs and U.S. shareholders to their pre-TCJA status. Of particular note, this relief will eliminate the tax information reporting burden these newly rendered CFCs suddenly faced for the 2018 tax year – namely the 1099 reporting obligation under Chapter 61.

Background

A CFC is a foreign corporation that is more than 50 percent owned by 10 percent shareholders that are U.S. persons (i.e., certain U.S. individuals, corporations, trusts, estates and partnerships). Generally, under Internal Revenue Code (IRC) section 318(a)(3), U.S. taxpayers could be attributed ownership in a foreign corporation if that ownership resulted from first attributing ownership in the foreign corporation to its foreign parent, and then attributing the same ownership interest downward to a U.S. subsidiary of the foreign corporate parent. Through this latter downward attribution, the foreign corporation could be deemed to have a U.S. shareholder and would resultantly be classified as a CFC. Historically, IRC section 958(b)(4) eliminated this last downward attribution step from being used to determine U.S. shareholders within the foreign corporation itself, thus preventing these foreign corporations from meeting the definition of a CFC. However, in 2017 the TCJA repealed section 958(b)(4), which required the application of downward attribution under section 318(a)(3) and led to many foreign corporations becoming CFCs.

As it relates to information reporting and withholding, this change presented two significant impacts:

  1. A CFC is a U.S. payor for purposes of Form 1099 reporting. Thus, the change in law under the TCJA meant that the entities that became CFCs due to the change in section 958(b)(4) no longer qualified for the exception from reporting of non-U.S. source income paid outside the US. Consequently, , these CFCs would be required to obtain documentation on many “foreign to foreign” payments to avoid certain mandatory presumption rules that would result in reporting (and possible backup withholding); and
  2. A CFC does not qualify for the portfolio interest exception.

The consequences of these downward attribution rules were thought to be an unintended consequence of the TCJA, and the text of the proposed regulations confirm this understanding, particularly as it relates to the first impact outlined above.

Effects of Proposed Regulations on Form 1099 Reporting Obligations

The proposed regulations provide that, for purposes of Form 1099 reporting, a these “new” CFCs will not be U.S. payors. As a result, the proposed regulations remove the Form 1099 reporting and backup withholding burdens placed on those foreign corporations classified as CFCs following the repeal of 958(b)(4). Specifically, Proposed Regulation §1.6049-5(c)(5)(i)(C) provides that, for purposes of chapter 61, a U.S. payor includes only a CFC that is a CFC without regard to downward attribution from a foreign person. 

Unfortunately, the proposed regulations do not address the second stated impact, the portfolio interest exception. This means that the foreign corporations that became CFCs as a result of the TCJA no longer qualify for the 0 percent tax rate under the portfolio interest exception. Thus, absent a treaty exemption, these entities will suffer a 30 percent withholding tax on certain interest payments that, prior to the law change, would not have been subject to U.S. taxation. 

KPMG Reminders and Observations 

From a U.S. information reporting and withholding perspective, the proposed regulations provide welcomed relief for those non-U.S. entities suddenly faced with Form 1099 reporting and backup withholding obligations as a result of the TCJA. 

Of particular importance, the proposed regulations explicitly provide that they may be relied upon until final guidance is issued. KPMG will continue to monitor any future guidance relating to the portfolio interest exception. 

For Your Reference 

The proposed regulations reversing the TCJA’s repeal of section 958(b)(4) has been published in the Federal Register (84 FR 52398) and can be reviewed here.

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