The Tax Cuts and Jobs Acts (TCJA) repealed § 958(b)(4) of the Code, which prevented downward attribution of stock ownership from a foreign person to a US person. That repeal has resulted in many foreign corporations being treated as Controlled Foreign Corporations (CFCs) even though they are not actually controlled (and sometimes not actually owned at all) by US shareholders, resulting in apparent outcomes that can be adverse or favorable to the taxpayer, depending on the situation. On October 1, 2019, Treasury and the IRS issued proposed regulations and a revenue procedure that address certain unintended consequences of the repeal of § 958(b)(4).
- The proposed regulations do not limit the broad literal scope of § 958 following repeal of § 958(b)(4), which repeal, according to the clear legislative history, was not intended to cause foreign corporations to be treated as CFCs with respect to US shareholders that are unrelated to the US shareholder to which ownership is attributed through downward attribution.
- The proposed regulations address certain unintended consequences of the repeal of § 958(b)(4) by restoring the pre-TCJA operation of those provisions, based on regulatory authority granted under the affected sections (rather than under § 958).
- Relief was not provided for all affected provisions. Most notably, no relief was provided for the portfolio interest exemption from tax on US source interest.
- Rev. Proc. 2019-40 somewhat limits the amount of due diligence required of a US owner of a foreign corporation and provides some relief in Form 5471 reporting, including the elimination of Form 5471 filing for an unrelated constructive US Shareholder.
For background, § 958 provides ownership attribution rules for determining whether a foreign corporation is a CFC and for related purposes. Section 958(a) contains rules regarding direct and indirect ownership, and § 958(b) contains rules regarding constructive ownership, which generally apply the principles of § 318(a) with certain modifications. Before the TCJA, § 958(b)(4) provided that § 318(a)(3) “shall not be applied so as to consider a United States person as owning stock which is owned by a person who is not a United States person” (so-called downward attribution).
The repeal of § 958(b)(4) causes additional foreign corporations to meet the definition of a CFC under the constructive attribution rules, many of which corporations have no direct or indirect ownership by US shareholders. The repeal produced many unintended results under collateral provisions that depend on a corporation’s status as a CFC for various purposes. To address certain of these instances, the proposed regulations modify or add regulations under the relevant Code section that uses the concept of a CFC. The result of the proposed regulations is that the pre-TCJA scope of the provisions is restored by turning off downward attribution from a foreign person to a US person to determine CFC status or as is otherwise relevant for purposes of these Code sections.
Eversheds Sutherland Observation: Although many practitioners had focused on the negative impacts of the repeal of § 958(b)(4), the repeal was also beneficial to taxpayers in some cases. The proposed regulations remove both the positive and negative effects of the repeal of § 958(b)(4) in certain areas.
Some of these returns to the status quo ante are generally taxpayer favorable:
- Section 267(a)(3)(B)(i), which generally defers deductions for accrued items payable to a related CFC until the year paid, does not apply to items other than interest expense if the related CFC is exempt from US tax on the amount owed due to a treaty obligation and does not have any § 958(a) shareholders;
- Section 706, which prescribes rules related to the determination of taxable years of partnerships and partners, is applied so that a CFC without any § 958(a) shareholders is treated as a foreign partner, and thus not taken into account;
- Sections 863(d) and (e) are applied as if § 958(b)(4) were still in effect, as announced in Notice 2018-13, to treat space and ocean income and international communications income as foreign source if it is earned by a foreign corporation that would not be a CFC if § 958(b)(4) were still in effect;
- The definition of a CFC in § 1297(e) is modified to disregard downward attribution from foreign persons so that the asset test for determining passive foreign investment company status is applied using the fair market value rather than the tax basis of assets; and
- A “US payor” for purposes of Form 1099 reporting only includes a CFC that is a CFC without regard to downward attribution. This is an important limitation for foreign banks.
Other returns to the status quo ante are generally adverse to taxpayers:
- Section 332(d), which generally subjects liquidations of certain US holding companies into non-CFC foreign parents to US withholding tax, is applied as if § 958(b)(4) were still in effect;
- The 5% ownership requirement to qualify for the catch-all gain recognition agreement triggering event exception in Treas. Reg. § 1.367(a)-8(k)(14) is determined as if § 958(b)(4) were still in effect;
- Section 672(f), which limits the scope of application of the grantor trust rules, is applied as if § 958(b)(4) were still in effect; and
- Application of the § 904 active rents and royalties exception, the financial services income rule, and the look-though rule is limited to foreign corporations that are CFCs without regard to downward attribution from foreign persons, which will result in certain income being included in the passive category rather than the general category.
Eversheds Sutherland Observation: Notably, no relief was provided related to the portfolio interest exemption (which generally precludes CFCs from qualifying for the exemption from tax on US source interest that might otherwise apply), as well as to numerous other implicated provisions, perhaps based on a view that the appropriate regulatory authority is not provided by the relevant statute. At a recent ABA Tax Section meeting, Treasury and IRS officials stated that they were open to further relief based on taxpayer comments.
Eversheds Sutherland Observation: Although the proposed regulations are to be effective on or after the date final regulations are published in the Federal Register, a taxpayer may apply the rules in the final regulations to the last taxable year of a foreign corporation beginning before January 1, 2018, and each subsequent year of the foreign corporation and to taxable years of US shareholders in which or with which such taxable years of the foreign corporation end, provided that the taxpayer and any US persons that are related to the taxpayer within the meaning of § 267 or § 707 apply the relevant rule consistently with respect to all foreign corporations. Presumably, a taxpayer may apply the future final regulations by filing an amended return. Moreover, a taxpayer may rely on the proposed regulations for any period before the date that the regulations are published as final regulations in the Federal Register. It would seem that, if a taxpayer relies currently on the proposed regulations for return filing purposes, a taxpayer may nonetheless file an amended return to the extent that the final regulations differ from the proposed regulations.
Eversheds Sutherland Observation: S. 2589 and its companion, H.R. 4509, were recently introduced and referred respectively to the Senate Finance Committee and the House Ways and Means Committee. S. 2589 and H.R. 4509 would amend § 958 to once again include the repealed language under § 958(b)(4). In addition, S. 2589 and H.R. 4509 would add a new provision, § 951B, that would address amounts that would be required to be included in the gross income of a “Foreign Controlled US Shareholder.” Proposed § 951B applies only to US shareholders that would hold a controlling interest through downward attribution, and thus targets the de-control transactions that were the target of the repeal of § 958(b)(4). Under the bill, the change would be retroactive to the last taxable year of a foreign corporation beginning before January 1, 2018 (i.e., the effective date of the repeal).
Rev. Proc. 2019-40
Rev. Proc. 2019-40 provides three safe harbors for determining information related to certain foreign corporations. Under the revenue procedure, penalties under §§ 6038 and 6662 will not be applied in cases where the taxpayer complies with the safe harbors. The revenue procedure also amends the filing requirements with respect to Form 5471, Information Return of US Persons with Respect to Certain Foreign Corporations.
Under the first safe harbor, the IRS will accept a US person’s determination that a foreign corporation is not a CFC if the person requests information from the foreign corporation as to whether it is a CFC and whether it owns stock of domestic corporations or other foreign corporations. The safe harbor does not apply if the US person has actual knowledge or publicly available information exists that is sufficient to determine whether the foreign corporation is a CFC.
The second and third safe harbors are premised on the concern that a US shareholder may not be able to obtain information regarding a foreign corporation’s operations that satisfies the evidentiary and other requirements of the Code. Both of these safe harbors allow the US shareholder to rely on what is termed “alternative information,” which, depending on availability, is generally entity-level financial statements prepared in accordance with GAAP or international or local accounting standards or records used by the foreign corporation.
The second safe harbor allows a taxpayer to use alternative information in determining its subpart F inclusion or GILTI inclusion amount with respect to a CFC, and the third safe harbor allows a taxpayer to use alternative information to determine a § 965 amount with respect to a specified foreign corporation (generally a 10% owned foreign corporation).
The revenue procedure also announces that the IRS intends to revise the instructions to Form 5471 to reduce or eliminate Form 5471 reporting requirements for Category 5 filers based on the shareholder’s ownership in and relation to the CFC. The following chart shows the proposed limitations on reporting.