Temporary regs address Section 245A loophole

New rules limit ability to claim dividends-received deduction

Temporary regs address Section 245A loophole The IRS has released temporary regulations (REG-106282-18) under Sections 245A and 954(c)(6) that limit gap-year and other planning strategies the IRS said used the dividends-received deduction (DRD) contrary to the legislative intent. They apply to transactions occurring after Dec. 31, 2017, and deny in whole or in part the Section 245A DRD or the Section 954(c)(6) exception to foreign personal holding company income. The regulations also prevent fiscal-year taxpayers from exploiting Section 245A due to a mismatch in the effective dates of the new legislation by applying Section 245A against income that should have been subject to tax under the global intangible low taxed income regime (GILTI) under Section 951A or otherwise subject to U.S. tax.

Background The TCJA replaced the long-standing system of taxing U.S. taxpayers on foreign earnings of their foreign corporate subsidiaries when the earnings are repatriated (or deemed repatriated) with a quasi-territorial system. The new system provides a 100% DRD to domestic corporations for foreign-source dividends received from 10%-or-more-owned foreign corporations that have not already been subject to the U.S. tax regime. The TCJA also allows a DRD on certain deemed income inclusions resulting from the disposition of lower-tier controlled foreign corporations (CFCs). Post TCJA, the DRD is part of a larger, closely interdependent set of international tax rules designed to subject earnings to either a the one-time transition tax under Section 965, Subpart F, or GILTI prior to them qualifying for 245A. The IRS’s stated concern was with specific transactions that don’t comport with that policy objective.

Key provisions of the temporary regulations The temporary regulations are artfully targeted, and only limit the Section 245A deduction in a relatively narrow set of circumstances. The regulations provide that for any tax year an otherwise qualifying taxpayer will be permitted to claim a Section 245A deduction only to the extent that the dividend exceeds the “ineligible amount.” The ineligible amount comprises 50% of the portion of the dividend attributable to extraordinary disposition amounts and 100% of amounts attributable to extraordinary reduction amounts.

An extraordinary disposition amount is the portion of dividend paid to a Section 245A shareholder out of the shareholder’s extraordinary disposition account. An extraordinary disposition account is derived from extraordinary disposition earnings and profits (E&P). The E&P resulting from an extraordinary disposition increases the account balance. For a disposition to be an extraordinary disposition, the disposition must be: (1) resulting from gains on certain dispositions of specified property, (2) occurring during the period between the Section 965 measurement date and the effective date of GILTI, (3) occurring outside the ordinary course of business of the foreign corporation, and (4) occurring with a related party. Specified property is property that produces gross income that would be subject to GILTI.

The second component of the ineligible amount for Section 245A is the extraordinary reduction amount. This limits the Section 245A deduction of a controlling Section 245A shareholder. Generally, a controlling Section 245A shareholder is one that owns more than 50% of the stock of the CFC. An extraordinary reduction amount would occur if either the controlling U.S. shareholder sells more than 10% or the stock of the CFC, or there is a greater than 10% change in the controlling Section 245A shareholders overall ownership of the CFC. In these instances, the extraordinary reduction account is increased by the E&P representing the amount of dividends paid by the corporation that are attributable to Subpart F income or tested income. But this is only to the extent such income would have been taken into account by the Section 245A shareholder had the reduction not occurred and had the income not otherwise been taken into account by a domestic corporation or a citizen or resident of the United States.

These provisions are largely designed to combat planning based on Section 951(a)(2)(B) and the repeal of Section 958(b)(4). Both provisions, absent this rule, appear to allow taxpayers to avoid subjecting income to the Subpart F and GILTI regimes in a way that allows the use of Section 245A to contravene congressional intent.

Both the extraordinary disposition rules and the extraordinary reduction rules have threshold limitations to limit compliance and administrative burden. No disposition will be considered an extraordinary disposition if it does not exceed the lesser of $50 million or 5% of the gross value of the CFC’s property. For extraordinary reductions, the threshold limitation applies where the sum of the CFC’s Subpart F income and tested income for the taxable year does not exceed $50 million or 5% of the CFC’s total income.

Lastly, the temporary regulations deny the Section 954(c)(6) look-through treatment for dividends paid by lower-tier CFCs to upper-tier CFCs, thereby causing a U.S. shareholder’s Subpart F inclusion to increase by the amount not eligible for look-through treatment. By way of background, Section 954(c)(6) provides an exception to the foreign personal holding income rule under Subpart F allowing a look-through exception for dividends paid from lower- to upper-tier CFCs that are not Subpart F or effectively connected income. The IRS expressed concern that the exception may cause dividends from one CFC to another to result in tax consequences similar to, but not dependent upon, those that can be effectuated using Section 245A in conjunction with the disqualified period, Section 951(a)(2)(B) or the repeal of section 958(b)(4). Under the temporary regulations, dividends paid from a lower-tier CFC to an upper-tier CFC are only eligible to apply the Section 954(c)(6) exception to 50% of the amount that would constitute an extraordinary disposition amount of the CFC. Similar to the rules associated with the disallowance of the Section 245A deduction, the Section 954(c)(6) limitation is measured by reference to a CFC’s gap period earnings from certain defined transactions. The resultant Subpart F inclusion applies both to individual and corporate shareholders of CFCs.

Next steps Due to the effective date for taxable years starting after Dec. 31, 2017, historical transactions should be reviewed as to the applicability of the temporary regulations, particularly in fiscal-year situations. Particular attention should be paid to extraordinary reduction amounts and whether any dispositions would be subject to these extraordinary reduction rules. Additionally, the changes made to Section 954(c)(6) relating to the impact on Subpart F on intercompany dividends should also be reviewed.

For more information contact:

David Sites
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
Washington National Tax Office 
Grant Thornton LLP
T +1 202 521 1522

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