Final regulations reduce the Code Sec. 956 amount for certain domestic corporations that own stock in controlled foreign corporations (CFCs). The regulations are intended to ensure that Code Sec. 956 is applied consistently with the participation exemption system under Code Sec. 245A.
Subpart F Rules
Under the subpart F rules, U.S. shareholders of a CFC are currently taxed on their pro rata shares of the CFC’s subpart F income without regard to whether the income is distributed to the shareholders ( Code Sec. 951(a)). Subpart F income generally includes passive income and other income that is readily movable from one taxing jurisdiction to another ( Code Sec. 952). A U.S. shareholder is a U.S. person (e.g., individual citizen, domestic corporation, etc.) that owns or is treated as owning 10 percent or more of the voting power or value of a foreign corporation ( Code Sec. 951(b)).
The U.S. shareholders of a CFC are taxed on their pro rata share of the CFC’s earnings that are invested in U.S. property during the tax year and not distributed or otherwise taxed (the “section 956 amount”). U.S. shareholders are effectively taxed on foreign source earnings brought back into the United States, on the theory that the returned earnings are substantially the same as a dividend. This rule is intended to create symmetry by taxing effective repatriations of earnings in the same manner as actual repatriations of earnings are taxed.
The Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97) added Code Sec. 245A, which allows a 100-percent participation exemption deduction—a participation dividends-received deduction (DRD)—for the foreign-source portion of dividends received from a specified 10-percent owned foreign corporation by a domestic corporation that is a U.S. shareholder of the foreign corporation. A specified 10-percent owned foreign corporation is any foreign corporation (other than certain passive foreign investment companies) in which a domestic corporation is a U.S. shareholder.
However, a domestic corporation cannot claim a participation DRD for a dividend on any share of the foreign corporation’s stock:
- that the domestic corporation holds for 365 days or less during the 731-day period that begins on the date that is 365 days before the date when the share becomes ex-dividend with respect to the dividend; or
- to the extent the domestic corporation is obligated to make related payments on positions in substantially similar or related property ( Code Sec. 246(c)).
Under the TCJA, a Code Sec. 956 inclusion is not eligible for the DRD because it is not a dividend.
Tax Treatment Symmetry
The participation exemption system has made the current broad application of Code Sec. 956 to corporate U.S. shareholders inconsistent with the Code section’s purposes and the scope of the transactions it is meant to address. In response, the regulations:
- 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, so that neither an actual dividend to a corporate U.S. shareholder nor the shareholder’s Code Sec. 956 amount will result in additional U.S. tax; and
- reduce the Code Sec. 956 amount otherwise determined regarding a U.S. shareholder for a CFC’s tax year ( “tentative Section 956 amount”) to the extent that the shareholder would be allowed a participation DRD had the shareholder received a distribution from the CFC equal to the tentative Code Sec. 956 amount (the “hypothetical distribution”).
The regulations include an ordering rule to address the previously taxed earnings and profits (PTEP) rules in Code Sec. 959. Under the ordering rule, the hypothetical distribution is treated as:
- first attributable to earnings and profits (E&P) described in Code Sec. 959(c)(2) (amounts attributable to subpart F inclusions); and
- then attributable to E&P described in Code Sec. 959(c)(3) (all other E&P).
The regulations also address the tentative section 956 amount with respect to domestic partnerships. The regulations provide that the tentative section 956 amount with respect to a domestic partnership is reduced to the extent that one or more of the domestic corporate partners would be entitled to a participation DRD if:
- the partnership received the amount as a distribution; and
- the remaining amount of the inclusion under Code Sec. 956 is allocated to the partners in the same proportion as net income would result to partners upon a hypothetical distribution.
The regulations will apply to tax years of CFCs beginning on or after July 22, 2019, and to tax years of U.S. shareholders in which or with which such tax years of CFCs end.
The regulations may be applied to tax years of CFCs beginning after December 31, 2017, and to tax years of U.S. shareholders in which or with which such tax years of CFCs end, provided the rules are applied consistently by the taxpayer and U.S. related persons.