Proposed regulations (REG-114540-18) coordinating sections 956 and 245A are scheduled to appear in the Federal Register on Monday, November 5, 2018.
Read text of the proposed regulations [PDF 207 KB] as published in the Federal Register.
This report provides initial impressions and observations about these proposed regulations.
For distributions made after December 31, 2017, a domestic corporate shareholder that is a 10% owner of a foreign corporation—including a controlled foreign corporation (CFC)—is generally eligible for a 100% deduction with respect to the foreign-source portion of a dividend received from the foreign corporation (a “section 245A dividend”).
Nevertheless, a repatriation of undistributed foreign earnings through a deemed section 956 inclusion is generally subject to a different tax treatment than a “section 245A dividend.” This is despite the fact that the historical justification for section 956 generally was to treat investments in U.S. property by a CFC in the same manner as a distribution by the CFC. Thus, with the new U.S. tax law, although “section 245A dividends” are fully deductible, a section 956 inclusion (e.g., a loan from a CFC or other investment in U.S. property by the CFC) would still be fully taxable to its U.S. shareholder (subject to a deemed foreign tax credit for the taxes properly attributable to that income).
Taxpayers may frequently be indifferent to actual distributions and investments in U.S. property because the new “global intangible low-taxed income” (GILTI) regime and the existing subpart F rules require a large portion of most CFC earnings to be currently included in a U.S. shareholder’s income and thus create lots of previously taxed income, and distributions and investments in U.S. property are both shielded by previously taxed income (PTI)—in which case the tax treatments will converge and only require a shareholder to take untaxed earnings into account after PTI is exhausted. Nevertheless, if a CFC earns significant income other than subpart F/GILTI income (e.g., subpart F income subject to the high-tax election), the CFC will have untaxed earnings. In that case, the different tax treatments, described above, of a “section 245A dividend” and section 956 inclusion could provide both a planning opportunity and a trap for the unwary.
For example, as a planning opportunity (and without regard to the proposed regulations discussed below), it would be possible for a CFC that had suffered foreign tax at a rate higher than the U.S. rate of 21% to choose to loan untaxed earnings to its U.S. shareholder, trigger a section 956 inclusion, and obtain the benefits of excess foreign tax credits attributable to that income, rather than to distribute the earnings in a “section 245A dividend”—in which case, the 100% dividends received deduction would be available, but foreign tax credits attributable to the earnings would be disallowed.
Conversely, as a trap for the unwary, a section 956 inclusion of low-taxed earnings would generally cause the CFC’s undistributed earnings to be subject to residual taxation in the United States, even though a dividend distribution might have been eligible for a full deduction under section 245A.
To address these discontinuities, Treasury and the IRS have issued these new section 956 proposed regulations to better harmonize the treatment of actual (section 245A) and deemed (section 956) dividend distributions.
For tax years of CFCs beginning on or after the date the regulations are finalized (i.e., if finalized in 2018, the regulations will be effective for calendar year taxpayers beginning on January 1, 2019), the section 956 regulations are modified to reduce the amount of the deemed inclusion that a U.S. shareholder would otherwise take into account (“the tentative section 956 amount”) by the amount of the section 245A deduction that the shareholder would otherwise be allowed if the shareholder had received a distribution from the CFC in an amount equal to the “tentative section 956 amount” (the hypothetical distribution).
A taxpayer can elect to apply the proposed regulations for tax years of CFCs beginning after December 31, 2017, provided that the taxpayer and persons related to the taxpayer consistently apply the proposed regulations with respect to all CFCs in which they are U.S. shareholders.
For example, assume a first-tier CFC loans $120 to its U.S. shareholder, and thus the “tentative section 956 amount” is $120. The amount of the section 956 deemed inclusion relating to this $120 is reduced to the extent of the “section 245A deduction” that would have arisen if the CFC had instead made a $120 dividend distribution to the U.S. shareholder.
The rules also apply for lower-tier CFCs, by treating the CFC as if it were directly owned by the U.S. shareholder and the CFC made a hypothetical distribution to the U.S. shareholder (through each entity by reason of which the U.S. shareholder indirectly owns the shares and pro rata with respect to the equity that gives rise to the indirect ownership) equal to the “tentative section 956 amount.” Thus, section 956 / section 245A parity is generally restored because the U.S. shareholder can no longer get better (or worse) treatment by making a section 956 investment.
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Chris Riccardi | +1 404 222 7187 | firstname.lastname@example.org
Barbara Rasch | +1 213 533 3382 | email@example.com
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