On October 31, 2018, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (the IRS) released proposed regulations (the Proposed Regulations) under section 956 of the Internal Revenue Code of 1986, as amended (the Code), that would reduce (and, in most situations, would eliminate) the amount that a domestic corporation that is a U.S. shareholder1 of a "controlled foreign corporation"2 (a CFC) is required to include in its income as a result of section 956 in connection with the CFC's investment of its earnings in U.S. property.
As discussed in more detail below, the Proposed Regulations were issued in order to coordinate the rules regarding the U.S. federal income taxation of a CFC's investment in U.S. property under section 956 with the participation exemption applicable to certain dividends received by a domestic corporation from a 10-percent owned foreign corporation under section 245A, which was added by the Tax Cuts and Jobs Act (the Act).
The Proposed Regulations, in most instances, will eliminate the adverse U.S. federal income tax consequences to domestic corporate borrowers of CFC guarantees and pledges.3 This may impact how lenders and borrowers negotiate provisions in loan agreements regarding guarantees and pledges of CFC assets and stock where the borrower is a domestic corporation. The Proposed Regulations will apply to taxable years of a CFC beginning on or after the date of publication of the Treasury decision adopting the Proposed Regulations as final regulations in the Federal Register are finalized and to taxable years of a U.S. shareholder in which or with which such taxable years of the CFC end. However, prior to the finalization of the Proposed Regulations, taxpayers may rely on the Proposed Regulations for taxable years of a CFC beginning after December 31, 2017 and for taxable years of a U.S. shareholder in which or with which such taxable years of the CFC end. Accordingly, CFCs of U.S. corporate borrowers may be able to provide guarantees and pledges immediately without triggering adverse U.S. federal income tax consequences to the domestic parent corporation.
Section 956 was enacted alongside the subpart F regime in 1962 in order to create symmetry between the taxation of dividend distributions of earnings from a CFC and the taxation of other transactions considered to be effective repatriations of earnings. Congress was particularly concerned that a CFC's investment of its earnings in U.S. property would be "substantially the equivalent of a dividend."4
As a result, section 956 generally requires a U.S. shareholder of a CFC to include in its income on an annual basis an amount equal to its pro rata share of any increase in the CFC's investment in U.S. property during the applicable taxable year (other than previously taxed earnings and profits of the CFC).
Subject to certain exceptions set forth in section 956 and the Treasury regulations promulgated thereunder, U.S. property generally includes: (i) tangible property located in the United States; (ii) stock of a domestic corporation; (iii) an obligation of a U.S. citizen or resident individual, domestic partnership or corporation, estate or trust; or (iv) a right to use certain intellectual property in the United States. In addition, a CFC's guarantee of debt of a related U.S. person and a pledge of stock of a CFC representing at least 66⅔ percent of the total combined voting power of all classes of voting stock of such CFC may be treated as an investment in U.S. property.
Both the House and Senate versions of the Act would have excepted domestic corporations that are U.S. shareholders in a CFC from the requirement that they recognize an income inclusion as a result of section 956 in respect of the CFC's investment in U.S. property because, under section 245A (discussed below), a U.S. parent corporation no longer could avoid U.S. federal income tax by causing earnings of a CFC to be reinvested in U.S. property rather than distributed.5 However, without explanation, the Act did not follow either the Senate or House modifications and retained section 956 in its current form.
The Act established a participation exemption system effectively exempting from U.S. federal income tax the foreign-source portion of dividends that are paid to a domestic corporation by a "specified 10-percent owned foreign corporation," which is a foreign corporation with respect to which a domestic corporation is a U.S. shareholder.6
Section 245A only applies to "dividends received" by a domestic corporation (not an individual) from a specified 10-percent owned foreign corporation and therefore does not apply to section 956 inclusions to a U.S. shareholder, which, as described in the notice of proposed rule making accompanying the Proposed Regulations, is not a dividend received from a CFC. As a result, prior to the Proposed Regulations, a corporate shareholder of a CFC could be taxed on income inclusions under 956 even though a dividend from such CFC would not be taxed under section 245A.
Proposed Regulations (Prop. Reg. § 1.956-1)
The Proposed Regulations fix the disparity in the U.S. federal income taxation of domestic corporations of distributions and amounts includible as a result of section 956 by reducing the amount includible in income as a result of section 956 to the extent that an actual dividend paid by the CFC would not be subject to U.S. federal income tax as a result of the deduction allowable under section 245A. This is accomplished by reducing the amount determined under section 956 with respect to each share of CFC stock directly or indirectly owned by a domestic corporation absent the rules contained in the Proposed Regulations (the Tentative Section 956 Amount) by the amount of the deduction under section 245A that would be allowed to the U.S. shareholder if the U.S. shareholder received as a distribution from the CFC an amount equal to the Tentative Section 956 Amount with respect to such share on the last day during the taxable year on which the foreign corporation is a CFC (the Hypothetical Distribution).
The Proposed Regulations contain special rules that apply for purposes of determining the amount of the deduction under section 245A to which a U.S. shareholder would be allowed by reason of the Hypothetical Distribution (as defined above). First, the Proposed Regulations modify the requisite holding period by requiring that the applicable share must be held by the domestic corporation for more than 365 days during the 731-day period beginning on the date which is 365 days before the last day of the taxable year on which the foreign corporation is a CFC (which will generally be December 31 of the immediately preceding year for calendar year CFCs). Furthermore, special rules exist for purposes of applying section 245A and the requirements set forth therein where a U.S. shareholder owns a share of stock of a CFC indirectly through one or more foreign corporations, partnerships, trusts or estates.
Treasury and the IRS requested comments on all aspects of the Proposed Regulations by December 5, 2018, including (i) the application of the Proposed Regulations to a domestic partnership with partners that include domestic corporations and other persons; (ii) the maintenance of previously taxed earnings and profits accounts under section 959 and the basis adjustments under section 961; and (iii) the interaction of the Proposed Regulations and the rules regarding the disallowance of hybrid dividends under section 245A(e).
Impact of Proposed Regulations
The Proposed Regulations are likely to impact how most parties negotiate loan agreements where the borrower is a U.S. corporation. Currently, in order to prevent guarantees or direct or indirect pledges by a CFC from giving rise to a deemed dividend to the U.S. borrower, loan agreements frequently provide that (i) a subsidiary of the U.S. borrower that is a CFC is not required to guarantee a debt obligation of the U.S. borrower and (ii) no more than 65 percent (or sometimes, two-thirds) of the stock of a subsidiary of the U.S. borrower that is a CFC can be pledged in support of the obligation of the U.S. borrower. Some loan agreements only limit such guarantees and pledges when they would give rise to adverse tax consequences to the U.S. borrower. In addition, some loan agreements apply such prohibitions to guarantees and pledges of so-called "FSHCOs," which are U.S. corporations substantially all of the assets of which are stock of CFCs.
However, as a result of the Proposed Regulations, lenders may begin asking for guarantees by CFCs and/or direct or indirect pledges of the assets of CFCs, as well as FSHCOs, where the borrower is a domestic corporation because the guarantees and/or pledges generally will not give rise to any inclusions to the U.S. borrower as a result of section 956 (so long as all of the CFC's undistributed earnings are foreign-source and the other requirements for the deduction under section 245A are satisfied). Although the Proposed Regulations will, in most instances, eliminate the adverse U.S. federal income tax consequences of CFC pledges and guarantees, obtaining guarantees and pledges from CFCs located in multiple jurisdictions likely will be difficult and will require the involvement of local counsel (which may mean that guarantees and pledges will be limited to material CFCs). Parties to loan agreements also should review the covenants contained in the loan agreement in order to determine whether the covenants prohibit pledges and guarantees only where they result in adverse tax consequences to borrowers—as CFC pledges and guarantees may now be required as a result of the Proposed Regulations' general elimination of the adverse U.S. federal income tax consequences arising from a CFC's investment in U.S. property. Additionally, domestic corporate borrowers under loan agreements should analyze carefully the capital structure of their CFCs in order to ensure the CFCs have no outstanding instruments (such as PECs or CPECs) that will give rise to hybrid dividends and should also ensure that all of the CFC's undistributed earnings are foreign-source earnings (generally earnings that are not attributable to (i) income that is effectively connected with the conduct of a trade or business within the United States and (ii) dividends received from a domestic corporation at least 80 percent of the stock of which (by vote and value) is owned by the CFC) because agreeing to CFC pledges or guarantees will still give rise to adverse U.S. federal income tax consequences to the domestic corporate borrower where the CFC will pay hybrid dividends or a portion of the CFC's undistributed earnings are not foreign earnings.
In addition, the Proposed Regulations give CFCs the ability to repatriate their earnings to a domestic parent corporation in a manner that is potentially more tax-efficient. Absent the Proposed Regulations, a CFC that is a tax resident of a country with a high withholding tax rate on dividends that wished to repatriate its earnings to the domestic corporation would have to choose between (i) distributing the earnings to the domestic corporation in the form of an actual cash distribution and subjecting the distribution to withholding taxes in the CFC's country of residence or (ii) loaning the earnings upstream to the domestic corporation, which would result in an investment in U.S. property that generally would be taxable to the domestic corporation as a result of the CFC's acquisition of U.S. property. However, under the Proposed Regulations, the CFC can now loan the earnings to the domestic corporation, which avoids the imposition of withholding taxes in the CFC's country of residence and also avoids an income inclusion to the domestic corporation as a result of section 956 (assuming that all of the CFC's undistributed earnings are foreign-source and the other requirements for the deduction under section 245A are satisfied).
Finally, it is worth noting that domestic corporations that are U.S. shareholders in CFCs with non-previously taxed earnings (including earnings that are not taxed under the GILTI rules added by the Act) and that pay a foreign income tax at a rate higher than 21% may decide to not rely on the Proposed Regulations for taxable years beginning before the date that the Proposed Regulations are finalized. Such domestic corporations could intentionally trigger an investment by the CFC in U.S. property and an income inclusion as a result of section 956 in order to generate an indirect foreign tax credit under section 960 as a result of the inclusion that could be used to offset the tax imposed on the inclusion and other income of the domestic corporation (provided, that there is sufficient foreign-source income in the applicable basket to utilize the foreign tax credit).
1 A U.S. shareholder is defined as a United States person that owns, or is considered as owning through the application of certain attribution rules, either (i) 10 percent or more of the total combined voting power of all classes of stock entitled to vote of a controlled foreign corporation or (ii) 10 percent or more of the total value of shares of all classes of stock of a controlled foreign corporation.
2 A CFC is any foreign corporation if more than 50 percent of (i) the total combined voting power of all classes of stock of such foreign corporation entitled to vote or (ii) the total value of the stock of such foreign corporation is owned, or is treated as owned through the application of certain constructive ownership rules, by U.S. shareholders on any day during the taxable year of such foreign corporation.
3 Domestic corporations should consider the state tax consequences of a CFC's investment in U.S. property in states that tax a CFC's investment in U.S. property and that have not adopted the participation exemption system created by section 245A.
4 S. Rep. No. 1881 at 88 (1962); S. Rep. No. 94-938 at 226 (1976).
5 Staff of H. Comm. on Ways and Means, Section-by-Section Summary of Tax Cuts and Jobs Act, H.R. 1.
6 In order to be eligible for the deduction under section 245A, the stock of the foreign corporation must be held by the domestic corporation for more than 365 days during the 731-day period beginning on the date that is 365 days before the ex-dividend date.
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