Among all the oddities of the Tax Cuts and Jobs Act of 2017 (TCJA), Congress’s preservation of Section 956 for corporate taxpayers has been among the most head-scratching. Earlier this week, the IRS acknowledged taxpayers’ concerns and issued proposed regulations that would substantially neuter this legacy provision.
Sec. 956 was an anti-abuse mechanism under the pre-TCJA deferral regime, under which the earnings of controlled foreign corporations (CFCs) were generally taxable only when distributed to a U.S. shareholder. In order to prevent taxpayers from accessing those earnings tax-free by other means, Sec. 956 treats a CFC’s investment in U.S. property similarly to a “deemed” dividend to its U.S. shareholders. For example, a loan by a CFC to its U.S. shareholder from previously untaxed earnings would cause those earnings to be included in the income of the U.S. shareholder.
The TCJA enacted Sec. 245A as part of a new participation exemption regime, allowing U.S. corporations a full dividends received deduction (DRD) for dividends paid by a 10 percent-owned foreign corporation. However, the TCJA did not repeal Sec. 956 for corporate shareholders (although the first draft of the House Bill did). Therefore, a disconnect exists between U.S. taxpayers who access earnings of CFCs by way of dividend and those who do so via investments in U.S. property. The U.S. corporation receiving a dividend from a CFC pays no tax; the U.S. corporation receiving a loan from its CFC pays 21 percent tax (assuming the CFC has sufficient untaxed E&P and insufficient previously taxed income to shield the inclusion).
The proposed regulations aim to fix this inequity. The regulations would limit a Sec. 956 inclusion to the amount that would have been taxable after application of the new Sec. 245A DRD, had the taxpayer received an actual dividend rather than a section 956 inclusion. In short, a corporate taxpayer that receives a loan of $100 from a CFC would not recognize income under Sec. 956 if that taxpayer would have been entitled to a $100 DRD if the CFC had paid a dividend instead. This “hypothetical dividend” applies through tiers of CFCs as well, so that a Sec. 956 inclusion from a lower-tier CFC may also qualify for the exclusion.
Sec. 956 does not simply apply to loans from CFCs to the U.S. One of the common sources of Sec. 956 exposure comes from U.S. taxpayers pledging stock of a CFC or CFCs guaranteeing the debt of their U.S. shareholders under a debt arrangement. In these cases, the CFC is treated as holding an obligation of a U.S. person, taxable under Sec. 956. The IRS’s proposed regulations could also apply beneficially to these arrangements.
It is important to bear in mind that in order to qualify for this hypothetical dividend exemption, taxpayers must meet the requirements of Sec. 245A. These include:
- Holding period requirement: the hypothetical dividend must be with respect to shares of stock of the CFC that the U.S. shareholder holds for more than 365 days during a rolling two-year period. In the case of stock held indirectly, Sec. 245A and related provisions will apply just as if the stock were held directly by the U.S. shareholder. Note that the holding period requirement can be satisfied with a holding period that includes days after the distribution.
- Hybrid dividend requirement: if any hypothetical dividend from a lower-tier CFC to an upper-tier CFC would constitute a hybrid dividend under Sec. 245A(e)(4), the exclusion will not apply.
- A hybrid dividend is a dividend from a CFC where the CFC receives any sort or local tax benefit, such as a deduction.
- Corporate requirement: non-corporate U.S. persons are not entitled to the Sec. 245A deduction; therefore, non-corporate U.S. persons do not qualify for this Sec. 956 exclusion.
A&M Taxand Says
While these regulations are only in proposed form, they come as a welcome relief to many taxpayers. However, before celebrating, be sure to review whether any hypothetical dividends qualify under Sec. 245A. Assuming your fact pattern qualifies, these proposed regulations would open up new avenues for repatriation, especially for taxpayers who have avoided paying dividends that would have been subject to foreign withholding taxes.
Until finalized, these regulations may be relied upon in proposed form for CFC years beginning after December 31, 2017.