Deemed participation better than no participation? Proposed regulations expand tax-free treatment to section 956 inclusions of certain shareholders

by Eversheds Sutherland (US) LLP
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On October 31, 2018, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued proposed regulations (Proposed Regulations) modifying the application of section 956 of the Internal Revenue Code of 1986, as amended (the Code), to extend the dividend exemption system implemented by Public Law 115-97, commonly known as the Tax Cuts and Jobs Act (the TCJA), to the application of section 956 to a corporate United States shareholder of a controlled foreign corporation (CFC).

  • The Proposed Regulations generally reduce the section 956 inclusion of a corporate United States shareholder in a CFC by an amount equal to the dividends-received deduction (DRD) under section 245A that would be available on a hypothetical actual distribution.
  • Section 956 continues to apply without reduction to individuals, regulated investment companies (RICs) and real estate investment trusts (REITs) consistent with the treatment of actual dividends received by such persons under section 245A. 
  • Symmetry between the treatment of actual and deemed dividends for corporate United States shareholders removes potential traps for the unwary, but reduces electivity that potentially could have been favorable to some taxpayers.

Things Are Different Under a Dividend Exemption System

The TCJA enacted a dividend exemption system that generally provides for a 100% DRD for the foreign-source portion of dividends received from a foreign corporation by a United States shareholder (generally, a 10% owner) that is a corporation. The DRD is not available with respect to dividends received by a United States shareholder from a CFC if the dividends are deductible by the CFC in computing its taxes (i.e., hybrid dividends). In addition, no foreign tax credits (FTCs) are allowed for any taxes paid or accrued with respect to any dividend that qualifies for the DRD.

Section 956 is an anti-abuse rule that taxes a CFC’s investment in United States property (e.g., a loan to a CFC’s domestic parent) as if the CFC had distributed its earnings to the United States. Prior to the implementation of the dividend exemption system, section 956 prevented CFC transactions that were “substantially the equivalent of a dividend” to a United States shareholder from being made without United States tax consequences. 

In the context of a dividend exemption system, where actual dividends are often tax-free, section 956 would result in disparate tax treatment of actual dividends and deemed dividends for corporate United States shareholders.

Eversheds Sutherland Observation: Because potential section 956 inclusions are reduced by the previously taxed earnings of the CFC, even without the Proposed Regulations the impact of section 956 was already significantly reduced for many taxpayers due to the substantial previously taxed earnings generated by the transition tax of section 965 and the new global intangible low-taxed income (GILTI) tax of section 951A. Nonetheless, taxpayers would have needed to closely monitor the earnings of their CFCs with investments in United States property to ensure that such investments did not inadvertently exceed the previously taxed earnings of the CFC.

Symmetry by Regulation

The Treasury and the IRS issued the Proposed Regulations to conform the consequences of effective repatriations under section 956 with those for actual dividends under section 245A. The Proposed Regulations reduce the inclusion that would otherwise be determined under section 956 by the amount of the deduction under section 245A that the United States shareholder would be allowed if the shareholder received as a distribution from the CFC an amount equal to such tentative inclusion on the last day during the taxable year on which the foreign corporation is a CFC. The Proposed Regulations generally treat a hypothetical distribution as going from the applicable CFC directly to the United States shareholder, but if there is any hybrid equity in the chain between such United States shareholder and the CFC, the hypothetical distribution is treated as being made through the chain of ownership in order to test whether any portion of the hypothetical distribution would be treated as a hybrid dividend that does not qualify for the 100% DRD under section 245A(e). 

Eversheds Sutherland Observation: Both the House and Senate versions of the TCJA would have addressed the disparate treatment of actual and deemed distributions under sections 245A and 956 by modifying section 956 to exclude United States shareholders that are corporations. The House-Senate Conference Committee did not modify section 965, but did not provide any explanation for not doing so. The lack of action by Congress could be read either as indicating that the disparate treatment was intentional or as a tacit recognition that a statutory change was unnecessary because of the available regulatory authority under section 956. 

The preamble states that absent the Proposed Regulations, section 245A would not apply to a section 956 inclusion, which is consistent with case law interpreting whether a section 956 inclusion is eligible for the preferential tax rate for “qualified dividend income” under section 1(h)(11).

Applicability and Comments

These changes are proposed to apply to tax years of a CFC beginning on or after the date they are published as final regulations in the Federal Register, and to tax years of a US shareholder in which or with which such tax years of the CFC end. For tax years of a CFC beginning before the date the Proposed Regulations are finalized, a taxpayer may rely on the Proposed Regulations for tax years of a CFC beginning after December 31, 2017, and for the tax years of a US shareholder in which or with which such tax years of the CFC end, provided that the taxpayer and the US persons that are related (within the meaning of sections 267 or 707) to the taxpayer consistently apply the Proposed Regulations for all CFCs of which they are US shareholders.

The IRS requests comments on the Proposed Regulations within 30 days after they are published in the Federal Register.

The Good and the Bad for US Corporate Taxpayers

For many corporate United States shareholders, the Proposed Regulations result in a welcome simplification and will allow taxpayers to make loans to their United States shareholders and investments for business purposes without creating additional US tax complexity or liability. Corporate United States shareholders may now have more flexibility to utilize guarantees from CFCs as well as pledges of CFC equity and assets to support US borrowings. Finally, the Proposed Regulations may allow taxpayers to avoid complex and costly restructurings to address section 956 concerns (e.g., US-foreign-US sandwich structures). The Proposed Regulations will be particularly beneficial to US corporate taxpayers that have an overall foreign loss and have not historically had the ability to use FTCs. 

Eversheds Sutherland Observation: Corporate United States shareholders should continue to be mindful of section 956, however, because it can still apply to them in certain situations, such as when the 12-month holding period applicable to section 245A is not satisfied or there is hybrid equity in the chain, even though no hybrid dividend is actually distributed. This can also occur when a portion of the hypothetical dividend would be from US sources.  The comfort generally provided by the Proposed Regulations makes these limited situations where section 956 would continue to apply to a corporate United States shareholder an even greater potential trap for the unwary, precisely because section 956 will rarely be a relevant consideration for these taxpayers.
Eversheds Sutherland Observation: Many credit facilities and security arrangements exclude CFCs (including their stock and assets) from generally applicable pledges and guarantees. While the rules in the Proposed Regulations would in many cases eliminate the primary reason for such exclusions for a borrower treated as a corporation for US federal tax purposes, borrowers should be wary of omitting such exclusions prior to the finalization of the Proposed Regulations, and should consider other potential reasons for such exclusions, including transfer pricing considerations with respect to guarantees. Non-corporate borrowers should continue to insist on the customary pledge limitations because they are still subject to a section 956 inclusion.

The Proposed Regulations limit electivity that potentially could have benefited certain taxpayers that would prefer taxable treatment of section 956 inclusions, particularly to the extent FTCs were made available.

Eversheds Sutherland Observation: Even absent the Proposed Regulations, changes to section 960(a) made it uncertain whether a section 956 inclusion would carry FTCs with it. It remains to be seen whether the Proposed Regulations are indicative of the view of the Treasury and the IRS with respect to whether FTCs may be deemed paid in connection with a potential section 956 inclusion that is not covered by the Proposed Regulations.

 

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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