Article featured on Thompson Reuters' Taxnet Pro, August 2020

On Friday, August 21, the IRS and Treasury released a new package of final and proposed regulations, continuing the practice of providing taxpayers with weekend reading. This week’s package finalizes the temporary section 245A regulations that were issued in June of 2019 (the 2019 regulations) to address certain potential tax avoidance transactions. Section 245A, which was enacted as part of the TCJA, allows a US corporation a 100% dividend received deduction (referred to as a participation exemption) with respect to dividends from a 10%-owned foreign corporation (an SFC). However, Treasury and the IRS were concerned that the participation exemption created opportunities for US corporations to inappropriately reduce their tax liabilities. Those opportunities were addressed by temporary regulations defining and dealing with transactions giving rise to an extraordinary disposition or an extraordinary reduction.

In this alert, we will discuss the general concepts of extraordinary dispositions and extraordinary reductions and highlight the important changes contained in the final and the more relevant provisions of the proposed regulations. 

Final Regulations

Extraordinary Dispositions

The extraordinary disposition rules address the availability of the participation exemption for certain distributions of earnings and profits (E&P) that were not subject to US taxation due to differing effective dates within TCJA.  Specifically:

• The transition tax, which was a one-time tax under section 965 on US shareholders (USSHs) on the deferred earnings of SFCs, measured as of November 2 or December 31, 2017. 
• The participation exemption, which is effective for distributions by SFCs made after December 31, 2017. 
• The section 951A (GILTI) provisions, which are effective for taxable years of CFCs beginning after December 31, 2017. 

Because of these varying effective dates, there was a period of time (the disqualified period, which was between November 3, 2017 or January 1, 2018 and the end of the fiscal year) during which earnings of a non-calendar year CFC were not subject to either section 965 or the GILTI rules, but were nevertheless eligible for the participation exemption if distributed.  In the IRS’s view, this timing mismatch was contrary to the intent of the participation exemption, which was to allow the participation exemption only with respect to SFC earnings that had been taken into account in determining amounts subject to the transition tax or GILTI.

To address this disconformity in effective dates, the extraordinary disposition rules of the 2019 regulations limited the availability of the participation exemption with respect to SFC dividends from E&P attributable to extraordinary asset dispositions. In general, an extraordinary disposition is a non-ordinary course disposition of specified property (generally, any property that produces tested income) to a related party during the disqualified period. Under the 2019 regulations, a transfer of intangible property (IP) was always treated as outside the ordinary course and therefore as an extraordinary disposition.

Final regulations change: Under the final regulations, certain IP transfers will not be considered extraordinary dispositions if the taxpayer had a reasonable expectation that the IP would be sold in the ordinary course of business to a third-party customer within one year. Certain IP that is never transferred in the ordinary course of business (such as trademarks and goodwill) does not qualify for this exception.

Earnings from extraordinary dispositions are accumulated in the shareholder’s extraordinary disposition account (EDA) with respect to the SFC, and 50% of the participation exemption with respect to dividends attributable to the EDA is disallowed. Dividends subject to this disallowance include actual dividends as well as deemed dividends that result from the sale of shares of a CFC. 

Final regulations change: The final regulations provide that the EDA account of the SFC is reduced to reflect section 956 inclusions by the USSH with respect to the SFC. This change is significant because the interplay of the section 956 regulations and the 2019 regulations could have resulted in the same extraordinary disposition effectively denying the participation exemption twice. 

Non-previously-taxed E&P that is not in the EDA (and is therefore eligible for the participation exemption) is considered distributed before any EDA E&P. Under the 2019 regulations, for this purpose, a shareholder’s share of non-EDA E&P was measured by its percentage ownership of stock of the SFC immediately after the distribution. 

Final regulations change: Under the 2019 regulations, if the distribution was part of or due to the sale of the stock of the SFC, a shareholder’s share of non-EDA E&P could have been fully eliminated.  To address this, the final regulations measure a shareholder’s share of non-EDA E&P based on its percentage ownership of stock of the SFC immediately before the distribution.

The EDA is reduced by distributions of extraordinary disposition E&P, and by distributions that fail to meet the criteria of the participation exemption (for example, certain hybrid dividends or where the shareholder fails to satisfy the one-year holding period requirement).

The extraordinary disposition rules also apply to dividends paid by a CFC to another CFC. For those dividends, the subpart F look-through rule of section 954(c)(6) is not available with respect to 50% of the dividend, so that the upper-tier CFC will (absent any other applicable exception, such as the same-country exception), recognize half the dividend as subpart F income.

The final regulations also provide helpful guidance on the implications of M&A activity for the EDA.

• The EDA will be eliminated in cases where no person is a section 245A shareholder of the relevant SFC after a transfer of stock of the entity. However, an anti-abuse rule targets transactions with a principal purpose to avail of the elimination rule. Certain transactions will be presumed to have a principal purpose of eliminating the EDA account, including those where an SFC reverts to having a section 245A shareholder within one year.
• The EDA generally will be eliminated upon a deemed acquisition of an SFC’s assets resulting from a section 338(g) election.
• The final regulations contain guidance on the carryover of EDA accounts in the case of section 355 transactions of an SFC, triangular asset reorganizations, and other types of taxable and tax-free reorganizations.

Extraordinary Reductions

Similar to the extraordinary disposition rules, the extraordinary reduction rules deal with transactions in which a distribution of CFC earnings could give rise to a participation exemption without having first been subjected to possible inclusion in a USSH’s transition tax or GILTI. However, unlike the extraordinary disposition rule, which disallows 50% of the participation exemption attributable to distributions from the EDA, the extraordinary reduction rule disallows 100% of the participation exemption for certain distributions.

As a general matter, an extraordinary reduction is a transaction in which a USSH disposed of an interest in a CFC other than on the last day of the CFC’s taxable year. The government’s concern is that the disposition could result in a deemed dividend so that the selling USSH would be able to claim a participation exemption, while the buyer either would not be subject to subpart F income or GILTI, or would be able to reduce its pro-rata share of Subpart F income or tested income of that CFC due to the dividend under section 951(b)(2)(B).

As a result, a distribution is attributable to an extraordinary reduction to the extent that the USSH’s pro-rata share of the CFC’s Subpart F income and tested income is reduced as a result of either: 

1. Certain transfers during the taxable year, in the aggregate, of more than 10%, by value, of the stock of the CFC that the USSH held at the beginning of the taxable year (as long as they also represent at least 5%, by value, of the outstanding stock of the CFC as of the beginning of the taxable year), or 
2. One or more transactions that cause the percentage of stock, by value, that the USSH owns as of the close of the last day of the taxable year to be less than 90% of the percentage, by value, that was owned either on the day during the tax year its ownership was highest, or on the day prior to the transfer, provided that the change is 5% or more.

Notably, these transactions need not occur between related parties, greatly increasing the potential scope of their application. For example, the sale of an interest in a CFC to an unrelated person may result in an extraordinary reduction.

Due to the disallowance of the participation exemption, the taxpayer must include the dividend in income in full.  The tax cost of this dividend may be greater than the tax saved on subpart F income or GILTI, as the tax on those inclusions might otherwise have been shielded by the section 250 deduction or foreign tax credits.  To avoid this result, the regulations allow USSHs to elect to close the taxable year of the CFC on the date of the transaction. Because the year closes on the transaction date, the USSHs must recognize their shares of subpart F income and tested income for the short period.

Final regulations clarification: The final regulations clarify that both the disposing USSH and all other USSHs of the CFC, including those who become USSHs by virtue of the extraordinary reduction transaction, must consent to the election.

Treasury deferred to a future project the treatment of extraordinary reductions that result from certain nonrecognition transactions, such as reorganizations and transactions governed by section 351 or section 721 or by the reorganization provisions of the Code.  Additionally, Treasury is studying the application of the participation exemption to dividends received by CFCs and how the participation exemption should apply to nimble dividends, which are dividends paid from current E&P by a corporation that has an accumulated deficit.

Proposed Regulations

While the final regulations largely address specific technical issues left unclear by the temporary regulations, the proposed rules are likely to have far broader application.

The proposed regulations address taxpayers’ concerns that the extraordinary disposition rules, together with similar rules in the GILTI regulations, could cause excess taxation. Specifically, the GILTI regulations treat a basis step-up in property acquired by a CFC from a related CFC during the disqualified period as “disqualified basis” (DQB) and do not allow deductions attributable to that disqualified basis to reduce tested income or subpart F income. For example, if CFC1 bought depreciable property from related CFC2 during the disqualified period, it cannot allocate and apportion the depreciation deduction attributable to the basis step-up to tested income. The deduction must be allocated to “residual income,” which is income that is not subpart F income, tested income, or income effectively connected with a U.S. trade or business.

Taxpayers expressed concern that a single transaction could be treated both as an extraordinary disposition and as giving rise to DQB, which could lead to excessive taxation.  In response to this concern, the proposed regulations offer mechanisms to reduce the EDA and DQB. In general, if an EDA of CFC1 results in the disallowance of the participation exemption, the related DQB in the hands of CFC2 ceases to be DQB; and to the extent deductions of CFC2 attributable to DQB reduce residual income, the related EDA account of CFC1 is reduced. The proposed regulations include separate sets of rules for “simple” and “complex” CFC structures.

Applicability Dates

The final regulations are retroactive and apply to taxable years ending on or after June 14, 2019.  Subject to certain consistency rules, taxpayers may elect to apply the final regulations to earlier taxable years.  The proposed regulations, as proposed, would apply to taxable years beginning on or after the date they are finalized and published in the Federal Register. As with the final regulations, taxpayers could elect to apply the proposed regulations (when and as finalized) to earlier taxable years, subject to consistency rules.

A&M Taxand Says

While the GILTI regime has undeniably received most of the post-TCJA attention, the participation exemption remains a valuable repatriation mechanism for domestic corporations. The extraordinary disposition rules are applicable only to transactions occurring during the disqualified period in 2018, the final and proposed regulations contain important provisions for taxpayers to consider today, such as putting ordinary course transfers of IP outside the scope of the rules. Taxpayers should carefully consider whether, under the final regulations, the treatment of transactions that had previously been treated as extraordinary dispositions should be revisited. 

Further, the proposed regulations offer important guidance on the interaction of the participation exemption with the GILTI regulations. A&M is happy to help taxpayers review their GILTI profile in light of these new rules to ensure that they are maximizing their deductions against tested income.