As part of the December 2017 federal tax reform law generally referred to as the Tax Cuts and Jobs Act or TCJA (even though that is not the law’s name), Congress created a so-called participation exemption by allowing corporations a 100 percent dividends-received deduction for dividends received from certain 10 percent or greater owned foreign corporations. However, Congress did not repeal or amend Section 956 of the Internal Revenue Code of 1986, as amended (IRC), which generally includes in the taxable income of 10 percent or greater U.S. shareholders of certain foreign corporations investments in the United States (e.g., a loan to the shareholder) by such foreign corporations. IRC § 956 treats the 10 percent or greater U.S. shareholders as if they received a taxable dividend from the foreign corporation. Accordingly, after enactment of the TCJA, U.S. tax law did not tax corporations subject to IRC § 956 on actual dividend distributions, but would tax the same corporation on a loan of the same amount to the U.S. corporation. The IRS has issued proposed regulations under IRC § 956 to remedy this oversight.
The United States taxes U.S. corporations on worldwide income, but applies a territorial system to foreign corporations (including those owned by U.S. C corporations). This disparate treatment has the unintended consequence of encouraging U.S. persons to shift income to foreign corporations owned by the U.S. person. To combat this with respect to passive and portable income, Congress created an anti-deferral regime in 1962 that applies to U.S. persons that own 10 percent or more of a “controlled foreign corporation,” or “CFC,” which generally is a foreign corporation in which one or more U.S. shareholders that own 10 percent of the foreign corporation collectively own over 50 percent of the foreign corporation. Pursuant to this regime, 10 percent U.S. shareholders of a CFC have to include in income their pro rata share of certain income of the CFC (this income is referred to as “subpart F income” and generally consists of passive and portable income).
Although this prevented deferral for a CFC’s subpart F income, no U.S. tax applied to the CFC’s non-subpart F income unless and until the CFC distributed such earnings as a dividend. Deferral potentially applied to non-dividend distributions (e.g., a loan from a wholly-owned CFC to its U.S. parent). To prevent this, Congress enacted IRC § 956 when creating the subpart F regime. The underlying basis for IRC § 956 was Congress’s determination that a CFC’s investment of its non-subpart F income in United States property was substantially equivalent to a dividend, and thus should be currently taxed like a dividend.
The participation exemption created by the IRC § 245A 100 percent dividends-received deduction means that, subject to certain exceptions, U.S. C corporations do not pay U.S. tax on actual dividend distributions by a CFC of its non-subpart F income. Accordingly, the new participation exemption moots the underlying policy rational for IRC § 956 for most situations. The House of Representatives and the Senate each passed a version of the TCJA that repealed IRC § 956. For reasons not explained in the Conference Report for the TCJA, the final version of the TCJA that emerged from the conference committee did not include repeal of IRC § 956. Because the general purpose of a conference committee is to resolve disagreements between the House and the Senate on a particular bill, it seemed odd that the conference committee dropped a provision about which both bodies agreed. The lack of a repeal of IRC § 956 is even more curious because the Joint Committee of Taxation estimated that repeal of IRC § 956 would cost about $2 billion. Accordingly, even with repeal of IRC § 956, the TCJA would have been under the $1.5 trillion ten-year cost required by the budget reconciliation process used by the Senate to pass the TCJA (i.e., retention of IRC § 956 was not a cost reduction needed for use of budget reconciliation).
Fortunately, the IRS realized that it no longer makes sense to tax dividend equivalents when an exemption applies to actual dividends.
IRC § 956(e) empowers the IRS to issue “such regulations as may be necessary to carry out the purposes of this section, including regulations to prevent the avoidance of the provisions of this section through reorganizations or otherwise.” The IRS has broadly interpreted this grant of authority to allow it to promulgate regulations beyond anti-avoidance so that the IRS may prescribe any rule that promotes the purposes of IRC § 956. As described above, Congress originally enacted IRC § 956 to ensure the same treatment for dividends by a CFC and investments in U.S. property by a CFC. Now that the participation exemption prevents U.S. taxation of a dividend, equal treatment requires that IRC § 956 not apply when a CFC invests that amount in U.S. property. Accordingly, the IRS’s proposed regulations “exclude corporate U.S. shareholders from the application of section 956 to the extent necessary to maintain symmetry between the taxation of actual repatriations and the taxation of effective repatriations.” In other words, if a U.S. corporate shareholder of a CFC would have been able to claim the benefits of the new participation exemption for an actual dividend distribution by the CFC, IRC § 956 does not apply to the U.S. corporation if the CFC instead uses those funds to make an investment in U.S. property.
The proposed regulations provide an important benefit to most corporate shareholders of a CFC. Nonetheless, one must remember that IRC § 956 still applies. Although the new participation exemption is broad, it does not apply to all CFC shareholders subject to IRC § 956. Notably, individuals and other noncorporate shareholders cannot claim the benefits of the participation exemption. Even for corporations, there are holding period requirements and regulated investment companies and real estate investment trusts cannot claim the benefit. The proposed regulations preserve the applicability of IRC § 956 for these shareholders.
Still, the proposed regulations significantly curtail IRC § 956, opening the door to potential non-U.S. tax planning. Although the participation exemption allows U.S. corporations to use dividends to repatriate foreign earnings with no U.S. tax, source-country withholding tax could apply so that the dividend triggers non-U.S. tax. IRC § 956 generally resulted in U.S. tax if a U.S. corporation used an alternative means (e.g., a CFC loan) to repatriate a CFC’s earnings in a manner not subject to source-country withholding. The proposed regulations allow U.S. corporations to structure repatriations in a manner that eliminates both U.S. and non-U.S. taxes.
The IRS’s proposed regulations provide relief for a matter overlooked by Congress. Still, Congressional inaction limited the scope of the relief, creating potential traps for the unwary. Please contact us if you have any questions.
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