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Initial impressions of proposed regulations coordinating sections 956 and 245A

KPMG report on proposed regulations

Proposed regulations (REG-114540-18) coordinating sections 956 and 245A are scheduled to appear in the Federal Register on Monday, November 5, 2018.


Related content

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.


Why did Treasury and the IRS issue 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.

What do the proposed regulations do?

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.

Implications of the proposed regulations

  • Under the proposed regulations, section 956 will become irrelevant to many corporate U.S. shareholders of CFCs either because the section 956 inclusion is sourced to previously taxed income (and thus, the section 956 inclusion is a distribution out of PTI) or because the hypothetical distribution is fully eligible for a section 245A deduction (and thus the “tentative section 956 amount” is reduced to zero).  Individuals are not eligible for the section 245A deduction, so section 956 will be more relevant to individual U.S shareholders of CFCs (because the hypothetical distribution would not reduce their “tentative section 956 amount”).
  • The proposed regulations might facilitate merger and acquisition (M&A) transactions by making it somewhat less pressing to unwind U.S. “sandwich structures” and otherwise tailor collateral packages to avoid section 956 inclusions (by pledging less than 66⅔ % of the stock of a CFC as collateral for the obligation of a U.S. shareholder).  It will be interesting to see whether lenders start requesting 100% of the shares of a CFC as collateral for these debts.  Taxpayers with hybrid debt issued by their CFCs should be wary of making such a pledge, as described below. 
  • Section 956 inclusions will still arise, even for corporate U.S. shareholders, if the hypothetical distribution of foreign earnings would give rise to a hybrid dividend—a dividend amount for which the CFC received a deduction or other tax benefit with respect to a foreign income tax—in which case, a section 245A deduction would not be available (and thus the hypothetical distribution would not reduce the tentative tax amount).  Thus, taxpayers with “PECs” (preferred equity certificates) or other hybrid instruments in their structure will need to continue to monitor for section 956 investments if they want to avoid a taxable inclusion of any untaxed foreign earnings of those CFCs.  The section 245A deduction also might not be available if the holding period for the CFC stock is not met or the CFC’s earnings are attributable to effectively connected income or dividends distributions from a U.S. subsidiary. 
  • It is not clear whether a foreign tax credit will be available for the taxes attributable to a section 956 inclusion that results because the hypothetical distribution would be a hybrid dividend that would fail to qualify under section 245A.  Future guidance from the IRS with respect to foreign tax credits hopefully would clarify this question.


For more information, contact a tax professional with KPMG’s Washington National Tax practice:

Steve Massed | +1 202 533 4738 |

Chris Riccardi | +1 404 222 7187 |

Barbara Rasch | +1 213 533 3382 |

Kevin Cunningham | +1 202 533 3346 |

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