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Proposed regulations balance Sections 956 and 245A

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Three people in a discussionThe IRS released proposed regulations (REG-114540-18) on Oct. 31 that have the effect of extending the dividends received deduction (DRD) to a domestic corporate U.S. shareholder otherwise experiencing a Section 956 inclusion.

The proposed rules come in response to the participation exemption system under Section 245A, which was enacted by the Tax Cuts and Jobs Act (TCJA). Under the participation exemption system, most earnings of certain foreign corporations that are repatriated to a corporate U.S. shareholder as a dividend are effectively exempt from taxation by virtue of an offsetting DRD under Section 245A. A Section 956 inclusion of a corporate U.S. shareholder, however, is not eligible for the DRD. The proposed regulations look to restore balance between actual dividends and amounts deemed “substantially the equivalent of a dividend” by reducing amounts subject to Section 956 if they otherwise qualify for the DRDs under Section 245A.

Background Section 956 was enacted in 1962 as an anti-abuse rule designed to ensure that foreign income could not be repatriated to the United States without being subject to U.S. taxation. According to the legislative history, the general purpose of Section 956 is to create symmetry between taxation of actual and “effective” repatriations, by subjecting effective repatriations to tax in the same manner as actual repatriations. Under these rules, when a controlled foreign corporation (CFC) is considered to have invested its current or accumulated earnings in certain types of U.S. property (i.e., a loan from a CFC to its U.S. shareholder), the investment is generally taxed to the U.S. shareholders in the year in which it is deemed made.

The TCJA instituted a participation exemption system under Section 245A for the taxation of foreign income. This system was established by permitting a U.S. shareholder a deduction equal to the foreign-source portion of a dividend received from a specified 10% owned foreign corporation, subject to a holding period requirement.

Overview of rules in the proposed regulations The proposed regulations under Section 956 promote symmetry between Sections 956 and 245A by aligning the original intent of Section 956 with the post-TCJA system of taxation. In effect, the proposed regulations tax “effective” distributions in the same manner as actual distributions. Very generally, under Section 245A and the proposed regulations, neither an actual dividend nor an amount determined under Section 956 will result in additional U.S. tax to corporate U.S. shareholders.

To accomplish this, the proposed regulations provide that the amount otherwise determined under Section 956 is reduced to the extent the U.S. shareholder would have been allowed a deduction under Section 245A had the U.S. shareholder received an actual distribution from the CFC equal to the amount determined under Section 956. As a result, and as made clear in the proposed regulations, existing limitations that apply to Section 245A also apply when determining the reduction in Section 956 (e.g., holding period requirement, hybrid dividends, etc.). Indirect shareholders of CFCs are subject to special rules, which apply the rules as if the U.S. shareholder owned the stock directly (but with consideration for rules addressing hybrid dividends in tiered structures under Section 245A(e)).

Section 956 will continue to apply without modification to U.S. shareholders other than corporate U.S. shareholders (i.e., those that do not qualify for Section 245A). For example, individual taxpayers are not eligible for the participation exemption system under Section 245A, and are thus ineligible to reduce a potential Section 956 inclusion under the proposed regulations. The preamble to the proposed regulations clarifies that individuals are not entitled to the reduction, irrespective of whether a Section 962 election is made. Section 956 continues to apply to real estate investment trusts and regulated investment companies without modification as they are also ineligible for the DRD under Section 245A.

The proposed regulations will generally apply to taxable years of a CFC beginning on or after the publication of final regulations in the Federal Register, and to taxable years of U.S. shareholders in which or with which the taxable year of the CFCs end. Until the proposed regulations are finalized, taxpayers may rely on them for taxable years of a CFC beginning after Dec. 31, 2017, and to taxable years of U.S. shareholders in which or with which the taxable year of the CFCs end (provided the taxpayer and U.S. persons related to the taxpayer consistently apply the proposed regulations with respect to all CFCs in which they are U.S. shareholders).

Next steps Certain taxpayers may have contemplated planning to avoid the implications of Section 956, or to use Section 956 inclusions to access unutilized foreign tax credits. Taxpayers should evaluate the impact of the proposed regulations on such planning.  Corporate taxpayers should also evaluate the increased flexibility allowing CFCs to invest in U.S. property, and other ramifications like the impact on pledges of foreign stock.

For more information contact:
David Sites
Partner
Washington National Tax Office 
Grant Thornton LLP
T +1 202 861 4104

David Zaiken
Managing Director
Washington National Tax Office 
Grant Thornton LLP
T +1 202 521 1543
 
Cory Perry
Senior Manager
Washington National Tax Office
Grant Thornton LLP
T +1 202 521 1509

Mike Del Medico
Manager
Washington National Tax Office
Grant Thornton LLP
T +1 202 521 1522

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