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Final Regs Exclude U.S. Corporate Shareholders from Section 956 Application

Final Regs Exclude U.S. Corporate Shareholders from Section 956 Application

IRS has issued final regs that reduce the amount determined under Code Sec. 956 for certain domestic corporations that own (or are treated as owning) stock in foreign corporations. Under the regs, neither an actual dividend to a corporate U.S. shareholder, nor such a shareholder's amount determined under Code Sec. 956, will result in additional U.S. tax.

 

Code Sec. 951(a)(1)(B) requires a U.S. shareholder of a CFC to include in gross income the amount determined under Code Sec. 956 (the "section 956 amount") with respect to the CFC to the extent not excluded from gross income under Code Sec. 959(a)(2). A U.S. shareholder's section 956 amount with respect to a CFC for a tax year is the lesser of (1) the excess (if any) of such shareholder's pro rata share of the average of the amounts of U.S. property held (directly or indirectly) by the CFC as of the close of each quarter of such tax year, over the amount of earnings and profits (E&P) described in Code Sec. 959(c)(1)(A) with respect to such shareholder, or (2) such shareholder's pro rata share of the applicable earnings of the CFC.

The Tax Cuts and Jobs Act (TCJA) established a participation exemption system for the taxation of certain foreign income. Under Code Sec. 245A(a), as added by TCJA, in the case of any dividend received from a specified 10% owned foreign corporation by a domestic corporation which is a U.S. shareholder with respect to such foreign corporation, there is allowed as a deduction an amount equal to the foreign-source portion of such dividend. A specified 10% owned foreign corporation is defined in Code Sec. 245A(b) as any foreign corporation (other than certain passive foreign investment companies) with respect to which a domestic corporation is a U.S. shareholder.

The purpose of Code Sec. 956 is generally to create symmetry between the taxation of actual repatriations and the taxation of effective repatriations, by subjecting effective repatriations to tax in the same manner as actual repatriations.

However, under the participation exemption system, earnings of a CFC that are repatriated to a corporate U.S. shareholder as a dividend are typically effectively exempt from tax because the shareholder is generally afforded an equal and offsetting dividends received deduction under Code Sec. 245A.

A section 956 inclusion of a corporate U.S. shareholder, on the other hand, is not eligible for the dividends received deduction under Code Sec. 245A (because it is not a dividend).
 
 

In 2018, IRS issued proposed Code Sec. 956 regs. The proposed regs 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. In general, under Code Sec. 245A and the proposed regs, respectively, neither an actual dividend to a corporate U.S. shareholder, nor such a shareholder's amount determined under Code Sec. 956, will result in additional U.S. tax.

To achieve this result, the proposed regs provide that the amount otherwise determined under Code Sec. 956 with respect to a U.S. shareholder for a tax year of a CFC is reduced to the extent that the U.S. shareholder would be allowed a deduction under Code Sec. 245A if the U.S. shareholder had received a distribution from the CFC in an amount equal to the amount otherwise determined under Code Sec. 956.

IRS has now finalized the proposed regs. which add a rule regarding CFCs that have prior year E&P described in Code Sec. 959(c)(1) and current-year E&P described in Code Sec. 959(c)(3) that do not result in an inclusion under Code Sec. 951 or Code Sec. 951A.

The final regs also include an ordering rule treating a hypothetical distribution as attributable first to E&P described in Code Sec. 959(c)(2), then to E&P described in Code Sec. 959(c)(3), consistent with the allocation of an amount determined under Code Sec. 956 pursuant to Code Sec. 959(f)(1). This rule, which differs from the general rule for allocation of distributions in Code Sec. 959(c) by not treating any amount as attributable to E&P described in Code Sec. 959(c)(1), is necessary to reflect the fact that the amount to which the hypothetical distribution applies is in fact a tentative section 956 amount. (Reg. §1.956-1(a)(3)(iii))

The final regs apply to tax years of a CFC beginning on or after May 23, 2019 and to tax years of a U.S. shareholder in which or with which such tax years of the CFC end. (Reg. §1.956-1(g)(4)).

However, consistent with the reliance allowed for the proposed regs, taxpayers may apply the final regs for tax years of a CFC beginning after Dec. 31, 2017, and for tax years of a U.S. shareholder in which or with which such tax years of the CFC end, provided that the taxpayer and United States persons that are related (within the meaning of Code Sec. 267 or Code Sec. 707) to the taxpayer consistently apply the regs with respect to all CFCs in which they are U.S. shareholders for tax years of the CFCs beginning after Dec. 31, 2017.  (Reg. §1.956-1(g)(4)).

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