On May 23, the Department of the Treasury and the IRS published final regulations (the final regulations) under Section 956 of the Internal Revenue Code of 1986, as amended (the Code). The final regulations generally adopt proposed regulations under Section 956 that had been published on Nov. 5, 2018 (the proposed regulations), and provide additional technical guidance. The final regulations principally affect credit support provided by a controlled foreign corporation (CFC) with respect to debt of a domestic corporation (a corporate U.S. shareholder) that owns (or is deemed to own) 10 percent or more of the vote or value of the stock of the CFC. A foreign corporation is a CFC if more than 50 percent of the total vote or value of its stock is owned, actually or constructively, by 10 percent (by vote or value) U.S. shareholders. The final regulations provide welcome relief to taxpayers in the wake of the sweeping changes to the international tax provisions of the Code effected by the enactment of the 2017 U.S. tax reform legislation, commonly referred to as the Tax Cuts and Jobs Act. The final regulations in most circumstances eliminate the adverse U.S. tax consequences to a U.S. corporate borrower when it pledges two-thirds or more of the voting stock of a CFC or causes a CFC to guarantee the debt or to pledge its assets to secure the debt.
Section 956, the Tax Cuts and Jobs Act and the Proposed Regulations
Section 956 was enacted to ensure that a CFC’s earnings that were not subject to immediate tax when earned would be taxed when effectively repatriated to the United States. Congress believed that an investment by a CFC of its earnings in U.S. property — such as through direct or indirect credit support provided by a CFC in respect of its U.S. corporate parent’s debt as described above — equated to a taxable dividend distribution by such CFC to its U.S. shareholder(s) and thus should be taxed in a similar manner. Therefore, a U.S. shareholder of a CFC that provides certain credit support of U.S. debt is required to include in gross income a deemed dividend in an amount determined under Section 956.
The Tax Cuts and Jobs Act upended the relative symmetry Congress had achieved with respect to actual and effective repatriations by CFCs to their U.S. shareholders by establishing a limited participation exemption system in respect of the taxation of certain foreign income. More specifically, in the case of any actual dividend received from a specified 10 percent owned foreign corporation by a corporate U.S. shareholder, new Section 245A generally allows a deduction equal to the foreign source portion of such dividend. The Tax Cuts and Jobs Act failed to extend relief similar to that afforded actual dividends to corporate U.S. shareholders under Section 245A to deemed dividends to such shareholders arising under Section 956.
Eligibility for the Section 245A deduction is subject to certain stringent requirements and limitations. For example, the Section 245A deduction is not allowed (i) if the stock of the CFC is held by the corporate U.S. shareholder for 365 days or less during the 731-day period beginning on the date that is 365 days before the date on which such share becomes ex-dividend with respect to such dividend, (ii) if the corporate U.S. shareholder is under an obligation to make related payments with respect to positions in substantially similar or related property, or (iii) where the dividend paid by the CFC is a “hybrid” dividend for which the CFC received a deduction or other tax benefit with respect to certain foreign taxes. As a result, corporate U.S. shareholders of recently acquired or newly formed CFCs may be ineligible for the Section 245A deduction.
In issuing the proposed regulations, the Treasury Department and the IRS acknowledged that as a result of the enactment of Section 245A, “the application of section 956 after the Act to corporate U.S. shareholders of CFCs that would qualify for section 245A deductions would result in disparate treatment of actual dividends and amounts ‘substantially the equivalent of a dividend’ — a result directly at odds with the manifest purpose of section 956.” The proposed regulations therefore sought to exclude corporate U.S. shareholders from the application of Section 956 such that, in general, neither an actual dividend to a corporate U.S. shareholder nor such a shareholder’s deemed dividend determined under Section 956 would give rise to additional tax to that shareholder. It should be noted that the proposed regulations had no impact on the applicability of Section 956 to other U.S. shareholders such as S corporations, regulated investment companies, real estate investment trusts and individuals. (As discussed below, the final regulations apply to certain domestic partnerships having one or more corporate U.S. shareholders.) To achieve their objective, the proposed regulations provided that the amount of the Section 956 deemed dividend is offset to the extent the corporate U.S. shareholder would have been allowed a deduction under Section 245A if the amount deemed received from the CFC under Section 956 had been an actual dividend.
The Final Regulations
The final regulations, like the proposed regulations, generally exempt corporate U.S. shareholders of CFCs from the application of Section 956 by providing that the amount otherwise determined under Section 956 (the tentative Section 956 amount) with respect to such shareholder for a CFC’s taxable year is reduced to the extent that the shareholder would be allowed a deduction under Section 245A if such shareholder had actually received a distribution from the CFC in an amount equal to the tentative Section 956 amount (the hypothetical distribution). In general, neither the receipt of an actual dividend by a corporate U.S. shareholder of a CFC nor such a shareholder’s tentative Section 956 amount will result in the imposition of additional U.S. federal income tax with respect to such shareholder under Section 245A and the final regulations, respectively. Thus, in usual circumstances, a CFC’s provision of a guarantee or pledge of its assets in support of its U.S. corporate parent’s indebtedness or a pledge by such parent of two-thirds or more of the stock of such CFC in support of its borrowing generally will no longer result in a deemed dividend includible in the income of the U.S. corporate parent under Section 956. U.S. corporate borrowers with CFC subsidiaries may wish to review their existing loan documents, as some agreements contain provisions requiring such borrowers to augment credit support from their CFCs in the event of a change in law or if doing so would not result in the imposition of additional tax.
The final regulations also include a new technical rule altering the existing ordering rules with respect to previously taxed income in the context of a hypothetical distribution in a manner intended to conform the allocation of such distribution to a CFC’s earnings and profits to the allocation of a Section 956 deemed dividend to a CFC’s earnings and profits. Such modification is in recognition of the fact that the amount to which a hypothetical distribution applies is in fact a tentative Section 956 amount.
Finally, the final regulations broadened the reach of the proposed regulations such that they may now apply to domestic partnerships that are U.S. shareholders of CFCs. The final regulations provide that the tentative Section 956 amount with respect to a domestic partnership is reduced to the extent that one or more domestic corporate partners of such partnership would be eligible for a Section 245A deduction if the partnership had received such amount as an actual distribution.
The final regulations do not address the interaction between the rules set forth therein and the exclusion of “hybrid” dividends from eligibility for the participation exemption under Section 245A. Presumably, absent additional guidance, the inclusion by a corporate U.S. shareholder of its tentative Section 956 amount would apply without benefit of the offset rule where the hypothetical distribution under the final regulations would constitute a hybrid dividend.
The final regulations generally apply to taxable years of a CFC beginning on or after July 22 and to taxable years of a U.S. shareholder in which or with which such taxable years of the CFC end. However, taxpayers may apply the rules set forth in the final regulations for taxable years of a CFC beginning after Dec. 31, 2017, and for taxable years of a U.S. shareholder in which or with which such taxable years of the CFC end, provided that such taxpayers and certain related U.S. persons consistently apply such rules with respect to all CFCs in which they are U.S. shareholders for taxable years of such CFCs beginning after Dec. 31, 2017.