The IRS issued Notice 2018-46, 2018-21 IRB, describing regulations that it intends to issue on an exception from the definition of “real property” and providing that taxpayers, pending the issuance of such regulations, can continue to rely on an exception to “U.S. real property” set out in 2015 temporary regulations that were set to expire on May 7, 2018.
Section 951(a) provides that a U.S. shareholder of a controlled foreign corporation (CFC) must include in gross income for the current tax year the shareholder’s pro rata share of certain items attributable to the CFC. This includes “the amount determined under … [Section] 956.” The amount determined under Section 956 with respect to a U.S. shareholder for the tax year is based on the shareholder’s pro rata share of the average amount of “U.S. property” held by the CFC during the tax year. Section 956(c) defines U.S. property that will cause an inclusion for a U.S. shareholder if held directly or indirectly by the CFC during the tax year. Specific types of property that constitute U.S. property are set out in Section 956(c)(1), and exceptions are provided in Section 956(c)(2). Obligations of a U.S. person generally are considered U.S. property; however, under Section 956(c)(2)(J), obligations of a U.S. person are excepted to the extent that readily marketable securities are posted as collateral (qualifying collateral exception). (Section references are to the Internal Revenue Code of 1986, as amended.)
On May 11, 2012, the IRS published temporary and proposed regulations under Section 956 that excepted from the definition of “U.S. property” certain obligations arising from upfront payments on cleared notional principal contracts (NPCs) with respect to which full initial variation margin was posted. On May 8, 2015, the IRS published temporary and proposed regulations under Sections 446 and 956. These regulations extended the exception to the definition of U.S. property, contained in the 2012 regulations, to certain obligations of U.S. persons arising from upfront payments made with respect to uncleared NPCs if certain conditions relating to full margin or cash collateral were met (the “full margin or cash collateral exception”).
In response to the May 2015 regulations, the IRS received comments regarding uncertainty about the application of the full margin or cash collateral exception, including whether the exception applies when a combination of cash and other property is posted as margin. Commenters requested that the full margin or cash collateral exception apply (1) to the extent that qualifying collateral has been posted as margin in respect of an upfront payment regardless of whether the remainder of the payment is collateralized (similar to the qualifying collateral exception) and (2) without regard to whether the underlying derivative financial instrument is an NPC.
Notice 2018-46 states that the IRS intends to publish regulations that will provide an exception from the definition of U.S. property, similar to the qualifying collateral exception, for an obligation (without regard to whether such obligation arises in connection with a derivative financial instrument that is or is not an NPC) of a U.S. person to the extent the principal amount of the obligation does not exceed the fair market value of cash and readily marketable securities posted or received as margin or collateral for the obligation in the ordinary course of its business by a U.S. or foreign person who is a dealer in securities or commodities. Prior to the issuance of the regulations, taxpayers may rely either on the provisions of Notice 2018-46 (including with respect to obligations arising before May 4, 2018) or on the full margin or cash collateral exception provided in the 2015 regulations.