international tax institute, inc. section 956: gone or not

International Tax Institute, Inc.

Section 956: Gone or Not Really?

January 22, 2019

Ninee DewarPhilip FriedKevin Liss

Introduction

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Overview of Taxation of Foreign Earnings Post-TCJA

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The new landscape for CFCs involves the following 4 regimes:

• Subpart F -- 21% rate with FTC, and carryforwards

• GILTI -- 10.5% rate with modified FTC

• Sec. 245A Eligible Distributions -- 0% rate

• Non-245A Eligible Distributions – 21% rate w/o credits

• Sec. 956 -- 21% rate w/o credits

Proposed Section 956 Regulations

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On October 31, 2018 the IRS and Treasury Department issued proposed regulations under section 956 (“Proposed 956 Regulations”) (REG-114540-18) pertaining to corporate U.S. shareholders.

The Proposed 956 Regulations seek to establish parity between actual dividends (which could benefit from Sections 245A) and constructive section 956 distributions.

According to the preamble:

“Absent the proposed regulations, corporate U.S. shareholders would need to continue to carefully monitor the application of section 956 to their operations, including provisions related to loans, guarantees, and pledges, to ensure that earnings were repatriated only through actual dividends, and therefore allowed a participation exemption, rather than through a deemed repatriation under section 956 subject to additional U.S. tax.”

Will the promise of the Proposed 956 Regulations be realized?

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- Section 956(e) (enacted as part of the Omnibus Budget Reconciliation Act of 1993) grants the Secretary the authority to prescribe “such regulations as may be necessary to carry out the purposes of this section [section 956], including regulations to prevent the avoidance of the provisions of this section through reorganizations or otherwise.”

- Per the preamble, the authority to promulgate regulations under section 956 is not limited to anti-avoidance rules. Rather, Treasury believes it also has the authority to ensure application of section 956 is consistent with the “purposes of the section” (mainly to ensure symmetry between the treatment of actual dividends and dividend equivalent distributions).

- Treasury and IRS determined that “[A]s a result of the enactment of the participation exemption system [section 245A], the current broad application of section 956 to corporate U.S. shareholders would be inconsistent with the purposes of section 956 and the scope of transactions it is intended to address”.

Proposed Section 956 Regulations – Statutory Authority

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• For applicable tax years, the amount determined under section 956 (the “tentative section 956 amount”) is reduced by the amount of the deduction under section 245A which the U.S. shareholder would have been allowed if the shareholder had received a distribution (i.e., a hypothetical distribution).

• Two key concepts:

- The “tentative section 956 amount” equals the section 956 inclusion that would have been recognized absent the Proposed 956 Regulations.

- Special rules are provided for determining the 245A deduction available to the hypothetical distribution (discussed below).

Proposed Section 956 Regulations – Overview

Proposed Section 956 Regulations – Effective Date

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• The Proposed 956 Regulations are applicable beginning on or after the first taxable year of a CFC following the regulations being adopted in final form (and to taxable years of a U.S. shareholder in which or with which such taxable year of the CFC end).

• Taxpayers may choose, however, to rely on the Proposed 956 Regulations for CFC taxable years that begin after December 31, 2017 (and to taxable years of a U.S. shareholder in which or with which such taxable year of the CFC ends).

• Comments (discussed later) on the Proposed 956 Regulations are due 30 days following the regulations being published in the Federal Register (November 5).

Proposed Section 956 Regulations – Why worry?

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While more limited in application under the Proposed 956 Regulations, Section 956 was not repealed by TCJA.

Certain conditions must be met before Section 956 will be effectively “turned off”.

If Section 956 inclusion is required/not turned off (e.g., because conditions are not/cannot be met), no Section 960 credits are associated with an inclusion under Section 956. See Section 904 regulations.

As a consequence, it would seem that Section 956 has become largely a trap for the unwary as opposed to a planning tool.

Requirements for Application of Section 956

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956 Investment

Relevant Earnings

Depletion of PTEP Shield

Lack of 245A Equivalency

1. Investment in US Property

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According to the legislative history of section 956, Congress determined that certain investments by a CFC of its earnings in United States property are “substantially the equivalent of a dividend” and enacted section 956 to provide similar treatment for dividends and certain investments in United States property constituting effective repatriations.

United States Property includes, with certain exceptions:

• Tangible property located in the United States

• Stock of a domestic corporation

• An obligation of a U.S. person

• The right to use certain IP in the United States.

Many issues are raised with respect to loans/credit support made by CFCs to U.S. affiliates. In general, a CFC is deemed to hold an obligation of a U.S. person if the CFC guarantees or pledges assets in support of an obligation of a related U.S. person.

2. Depletion of PTEP Shield

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Post-TCJA, PTEP comes in many forms, among others:

• 965(a) PTEP• 965(b) PTEP• 951(a)(1)(A) Subpart F PTEP• 951(a)(1)(B) Sec. 956 PTEP• 951A GILTI PTEP

Section 956 PTEP effectively reduces the amount of investment in U.S. property.

Section 959(f)(1) attributes section 959(c)(2) PTEP (subpart F and GILTI PTEP) to an investment in U.S. property, creating a “PTEP shield.”

This shield is lost upon distribution of PTEP up a tier, even to an intermediate CFC. Section 959(f)(2).

3. Non-PTEP Earnings

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TCJA produced a world replete with PTEP (Sec. 965 transition tax, subpart F, and GILTI, and others). These earnings cannot “fill” a section 956 inclusion.

Notwithstanding these PTEP earnings, the following earnings are potentially available for inclusion under section 956:

o Net deemed tangible income return (10% of QBAI),

o High-taxed subpart F income (section 954(b)(4) election),

o Tested income offset by a tested loss,

o Pre-1987 E&P (this E&P was not subject to section 965),

o E&P acquired from a foreign entity that has not been subject to U.S. tax, and

o E&P arising in “gap” period for fiscal year taxpayers.

3. Non-PTEP Earnings: Ordering rule in calculating subpart F, GILTI, and Section 956 inclusions:

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1. Determine any subpart F inclusion

• Taxpayers must first determine a CFC’s subpart F income in order to exclude the amount from tested income.

• Subpart F inclusion increases PTEP.

2. Determine any GILTI inclusion

• The preamble to the proposed GILTI regulations provides that a GILTI inclusion is determined prior to any section 956 inclusion (page 37 of proposed 951A regulations).

• GILTI inclusions increases PTEP.

3. Take into account any actual distributions (Sec. 959(f)).

4. Determine tentative section 956 inclusion (in excess of current-year and historical PTEP remaining in entity after step 3).

5. Determine any reduction attributable to a 245A deduction associated with a hypothetical distribution.

4. Section 245A Equivalency

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General Rule. Section 245A generally provides a 100% DRD for the foreign-source portion of dividends received by a US corporation from foreign corporations with respect to which it is a US shareholder.

Foreign-source portion of a dividend. The “foreign-source portion” of any dividend corresponds to earnings that are neither ECI nor certain dividends received from domestic corporations.

Lower-tier dividends. According to the Blue Book, a lower-tier distribution shall be treated as subpart F to the corporate U.S. shareholder, subject to a Sec. 245 DRD to the same extent an actual dividend would be.


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Holding Period Requirement. No DRD is permitted unless the relevant share of stock is held by the domestic corporation for more than 365 days during a 731-day period which straddles the ex-dividend date.

• For purposes of determining whether a U.S. shareholder satisfies the holding period requirement of Section 246(c) to claim a Section 245A deduction, for purposes of the hypothetical distribution both direct and indirect ownership are taken into account.


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Hybrid Dividends. The DRD is not available for a hybrid dividend. “Hybrid dividend” arises where a CFC receives a deduction or other tax benefit for foreign income tax purposes with respect to a dividend, tracked in a “hybrid deduction accounts.”

• If a U.S. shareholder owns a share of CFC stock indirectly, section 245A(e) (relating to hybrid dividends) applies as if the hypothetical distribution was distributed up through the chain entity by entity.

Foreign tax credit disallowance. No FTC is available for any dividends receiving a DRD. And no FTC is available with respect to a hybrid dividend.

Examples

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Prop. Reg. sec. 1.956-1(a)(3)Example 1 – Simplified (Foreign-Source Portion)

USP

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CFC

Facts:

• USP owns all of the stock of CFC and meets the holding period requirement under section 246(c).

• CFC has undistributed earnings of $100, $90 of which are foreign sourced. CFC has no PTI.

• CFC has applicable earnings of $100 and holds an obligation of USP with an adjusted basis of $120 on every day during the taxable year.

Analysis:

• USP’s tentative section 956 amount is $100 (the lesser of USP’s pro rata share of the average amount of U.S. property held by CFC ($120) and its pro rata share of CFC’s applicable earnings ($100)).

• Under the Proposed 956 Regulations the tentative section 956 amount is treated as a hypothetical distribution with respect to CFC1 stock.

• The hypothetical distribution would result in a $90 deduction under section 245A (that is, an amount of the dividend that bears the same ratio to the dividend as the $90 of undistributed foreign earnings bears to the $100 of undistributed earnings).

• Thus, USP’s section 956 amount with respect to CFC is $10, its tentative section 956 amount ($100) reduced by the amount of the deduction that USP would have been allowed under section 245A ($90).

$120 USP Obligation

$90 F-S Earnings$10 US-S earnings

Prop. Reg. sec. 1.956-1(a)(3)Example 2 – Simplified (PTI Shield)

USP

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CFC

Facts:

• USP owns all of the stock of CFC and meets the holding period requirement under section 246(c).

• CFC has undistributed earnings of $100, all of which are described in section 959(c)(2) (subpart F PTI).

• CFC has applicable earnings of $100 and holds an obligation of USP with an adjusted basis of $120 on every day during the taxable year.

Analysis:


• USP would not be allowed any deduction under section 245A with respect to the $100 hypothetical distribution because it would be PTI by reason of section 959(a) and (d). Accordingly, USP’s section 956 amount is $100.

• Under, sections 959(a)(2) and 959(f)(1), USP’s inclusion under section 951(a)(1)(B) with respect to CFC is $0, because USP’s section 956 amount with respect to CFC does not exceed the earnings and profits of CFC described in section 959(c)(2) with respect to USP.

$120 USP Obligation

100 959(c)(2) earnings

Prop. Reg. sec. 1.956-1(a)(3)Example 3 (Recently Acquired Shares)

USP

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CFC1

Facts

• As of 11/30 USP wholly owns CFC1 which owns 70% of CFC2 (the other 30% is owned by an unrelated party). All entities have calendar year ends.

• On 12/1 CFC1 acquires the remaining 30% of CFC2 and sells such shares 7 months later.

• CFC2 has undistributed earnings of $120 (all of which are foreign earnings) and applicable earnings of $120.

• CFC2 held an obligation of USP with an adjusted basis of $100 on every day in the taxable year.

Analysis

• USP indirectly owns CFC2 at the end of Y1. Therefore, its tentative section 956 amount is $100 (the lesser of USP’s pro rata share of the average amounts of U.S. property held by CFC2 ($100) and its pro rata share of CFC2’s applicable earnings ($120)).

• USP would meet the holding period requirement under section 246(c) for 70% of CFC2 stock. However, with respect to the 30% of stock acquired on 12/1/Y1, since USP did not hold this stock for 365 days USP does not meet the section 246(c) holding period requirement.

• Thus, USP would have been allowed a section 245A deduction with respect to 70% of the $100 hypothetical distribution. This results in a $30 section 956 inclusion by USP ($100 tentative section 956 inclusion - $70 section 245A deduction).

70%

CFC2

UnrelatedParty

30%

USP

CFC1

100%

CFC2

As of 11/30/Y1

As of 12/1/Y1

$100 USP Obligation

$100 USP Obligation

Other Examples: Hybrid Equity

USP

Facts:

• USP owns hybrid equity in CFC1 with a hybrid deduction account of 60.

• USP indirectly owns all of the stock of CFC2 and meets the indirect holding period requirement under section 246(c).

• CFC2 has undistributed earnings of $100, all of which are foreign sourced. CFC2 has no PTI.

• CFC2 has applicable earnings of $100 and holds an obligation of USP with an adjusted basis of $120 on every day during the taxable year.

Analysis:


• For purposes of applying the hybrid dividend rule, CFC2 is deemed to make a distribution to CFC1, which is deemed to make a distribution to USP.

• The hypothetical distribution from CFC2 to CFC1 is expected to qualify for CFC-look-through under section 954(c)(6) and, as a consequence, would not be tested under section 245A.

• The hypothetical distribution from CFC1 to USP would be partly ineligible for 245A due to the Hybrid Dividend Account.

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CFC1

$120 USP Obligation

CFC2

Hybrid Deduction Account of 60

$100 F-S Earnings

Other Examples: Owners ineligible for Sec. 245A

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Facts:

• A US individual owns 10% of vote of FP.

Analysis:

• By reason the repeal of section 958(b)(4), FC1 is considered a CFC.

• As a 10% shareholder, US individual is exposed to potential inclusions under section 956 without any relief under the Section 245A equivalency approach (although there may be PTI shield or lack of non-PTEP earnings).

• FC1’s ownership of US Sub2 is considered an investment in US property, as well as FC1’s loan to US.

• Proposed technical corrections language could improve result for US individual.

FP

FC1

Loan or other Credit support

US Sub1

10% by vote or value

US Sub2

Individual

What’s the Upshot?

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Private equity/partnership structures still exposed to section 956 and must consider carefully if 10% U.S. shareholder status present.

Guarantees and Pledges

• Lenders can be expected to be more aggressive in requesting pledges and guarantees

• Borrower acquiescence not assured

• Due to evergreen nature of pledges and guarantees, careful monitoring required.

Cash Pooling

• Historically, US affiliates typically not part of non-US cash pool vehicle to avoid Section 956.

• With monitoring, this prohibition could be relaxed.

Comments

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Comments on the Proposed 956 Regulations

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Comments are requested on “all aspects” of the Proposed 956 Regulations. Comments are due 30 days following the regulations being published in the Federal Register. Comments are specifically requested on:

• The interaction of the Proposed 956 Regulations with partnership structures (see next slide),

• Maintenance of PTI accounts and basis adjustments under section 961 (Treasury and IRS are working on comprehensive PTI and basis adjustment regulations), and

• Interaction of the Proposed 956 Regulations with section 245A(e).

Comments requested on partnership structures

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CFC

Facts:

• CFC holds an obligation of USPS (a domestic partnership) which creates a section 956 inclusion at the partnership level.

Analysis:

• The proposed regulations request comments on the following approaches:

• Aggregate Approach: Reduce the amount otherwise determined under section 956 at the partnership level if the partnership has a corporate U.S. tax partner that would be allowed a deduction under section 245A if the partnership had received the amount as a distribution, alternatively;

• Entity Approach: Determine the section 956 amount at the partnership level without regard to the status of its partners but then provide to any corporate U.S. shareholders distributive share of the section 956 inclusion is not taxable.

USPS obligation

USPS

USP Foreign Co.

international tax institute, inc. section 956: gone or not

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