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How Section 245A Temporary Regs Limit Dividends Received Deductions, Part 2

Posted on Aug. 12, 2019

Taxpayers selling stock of a controlled foreign corporation will see their section 245A dividends received deduction (DRD) as well as their section 954(c)(6) foreign personal holding company income (FPHCI) exception limited in some instances under new temporary section 245A regs.

The new temporary regs (T.D. 9865) limit the DRD and FPHCI exception if a taxpayer disposes of enough CFC stock to constitute an extraordinary reduction (ER) in its ownership.

An extraordinary disposition (ED) can also cause some dividends to become ineligible for a section 245A DRD or the section 954(c)(6) FPHCI exception. (Prior coverage: Tax Notes Int’l, Aug. 5, 2019, p. 475.) This article describes how an ER can do the same thing. Ordering rules provide that the ER limits apply to dividends before the ED limits.

The section 245A temporary regs limit the DRD to the portion of a dividend that is not an ineligible amount, which is the sum of:

  • 50 percent of the dividend portion attributable to earnings and profits generated by gain from an ED; and

  • the portion of a dividend attributable to E&P in a year that the section 245A shareholder reduces its CFC ownership percentage in an ER.

Extraordinary Reductions

Reg. section 1.245A-5T(e) contains the ER rules that limit a controlling section 245A shareholder’s ability to take the DRD. A section 245A shareholder is a domestic corporation that is a United States shareholder of a specified 10-percent owned foreign corporation (SFC) as defined in section 245A(b)(1).

The ER rules introduce the “controlling section 245A shareholder” (CSTS), which is any section 245A shareholder that owns more than 50 percent of the CFC’s vote or value. In determining if a section 245A shareholder is a CSTS, all CFC stock owned by a related party, or persons acting in concert to undertake an ER, is considered owned by the section 245A shareholder.

An ER amount is the lesser of:

  • the amount of a dividend received by a CSTS from a CFC during a tax year in which an ER of the CSTS’s CFC ownership occurs; or

  • the sum of the CSTS’s pre-reduction pro rata share of the CFC’s subpart F income and tested income reduced by the prior ER amount.

An ER of a CSTS’s CFC ownership occurs during a tax year if either of two conditions is satisfied:

  • during the tax year, the CSTS transfers more than 10 percent (by value) of the CFC stock that the CSTS owns at the beginning of the year, provided the transferred stock is at least 5 percent of the CFC outstanding stock value; or

  • as a result of transactions that occur during the year, the percentage of CFC stock value that the CSTS owns on the last day of the year is less than 90 percent of the initial percentage, provided the difference between the initial and end-of-year percentage is at least 5 percentage points.

For the second condition, initial percentage is the CSTS’s stock value ownership percentage on:

  • the day the CSTS owns its highest percentage of stock value; and

  • the day before the first day that stock was transferred in the preceding year in a transaction occurring under a plan to reduce the CSTS’s stock value ownership percentage.

A CSTS’s pre-reduction pro rata share of subpart F income or tested income is the CSTC’s pro rata share of the CFC’s subpart F income or tested income under section 951(a)(2) and reg. sections 1.951-1(b) and (e), section 951A(e)(1), and reg. section 1.951A-1(d)(1). It is based on the CSTS’s ownership of CFC stock immediately before the ER, but only to the extent that the subpart F income or tested income is not already included in the CSTS’s income directly under those sections.

A CSTS’s pre-reduction pro rata share of subpart F income or tested income is reduced by amounts taken into account by U.S. tax residents. The reduction is equal to the amount that a U.S. tax resident’s pro rata share of subpart F income or tested income is increased as a result of the CSTS’s stock transfer during the year an ER occurs.

A CSTS’s transfer of CFC stock that would otherwise give rise to an ER does not do so if the tax year of the CFC ends immediately after the transfer. Additionally, no amount is considered an ER amount (or tiered ER amount) if the CSTS elects to close the CFC’s tax year for all purposes at the end of the day the ER occurs.

Tiered Extraordinary Reductions

Like a tiered ED, a tiered ER causes limits to the FPHCI exception in section 954(c)(6). The tiered ER rules are in reg. section 1.245A-5T(f). If an ER occurs regarding a lower-tier CFC and an upper-tier CFC receives a dividend from the lower-tier CFC in the same year as the ER, then only the amount of the dividend that exceeds the tiered ER amount is eligible for the FPHCI exception. Lower-tier CFCs are CFCs whose stock is owned by another CFC, and upper-tier CFCs are CFCs that own stock in another CFC.

Tiered ER amount means the dividend amount equal to the lower tier CFC’s subpart F income plus tested income multiplied by the upper-tier CFC’s stock value ownership percentage of the lower-tier CFC, minus:

(A) each U.S. tax resident’s pro rata share of the lower-tier CFC’s subpart F and tested income;

(B) the sum of each prior-tiered ER included in an upper-tier CFC’s subpart F income due to the section 245A(e) hybrid rules;

(C) the sum of the prior ERs of each CSTS of the lower-tier CFC whose stock was owned by the CSTS for a portion of the year but is owned by an upper-tier CFC at the time of the dividend; and

(D) the amount in (B) multiplied by the sum of each U.S. tax resident’s pro rata share of subpart F income and tested income attributed to shares of the lower-tier CFC acquired by the U.S. tax resident from the lower-tier CFC.

A de minimis rule provides that no amount is an ER amount if the CFC’s subpart F plus tested income does not exceed the lesser of $50 million or 5 percent of the CFC’s total income.

Rationale

A section 245A shareholder of a CFC could transfer CFC stock or dilute its CFC ownership and (absent limitation) the section 245A deduction would be allowed. But for ownership changes, the shareholder would have been taxed under the subpart F or global intangible low-taxed income regimes. Unlike an ED that causes this result only if it occurs during a disqualified period, an ER can occur in any tax year ending after the Tax Cuts and Jobs Act took effect.

For example, section 951(a)(2)(B) reduces a U.S. shareholder’s pro rata share of CFC subpart F income or tested income for dividends a different taxpayer receives in respect of the same CFC stock. If the section 245A DRD were to apply to those dividends, E&P that would otherwise be taxed under subpart F or GILTI would escape U.S. tax.

If a section 245A shareholder transfers CFC stock to another section 245A shareholder, a dividend (including by reason of section 1248) paid by the CFC to the transferor during the year of the transfer might both:

  • be excluded from the transferor’s income because of a section 245A DRD; and

  • reduce the transferee’s pro rata share of the CFC’s subpart F or tested income under section 951(a)(2)(B), causing double nontaxation.

The section 951(a)(2)(B) formula allows subpart F income and tested income to be reduced by the income inclusion multiplied by the fraction of the days of the year during which the shareholder did not own the CFC stock.

Similarly, a U.S. shareholder can transfer CFC stock to a foreign person so that the CFC remains a CFC but has no U.S. shareholder that owns its stock. Before the TCJA, section 958(b)(4) prevented attribution of stock ownership from a foreign person to a U.S. person. Because the TCJA repealed section 958(b)(4), a foreign corporation may be treated as a CFC despite having no U.S. shareholder that recognizes income under section 951 or 951A.

A U.S. shareholder may transfer CFC stock to a person that will not be taxed under subpart F or GILTI, but the CFC’s E&P distributed as a dividend (including by reason of section 1248) to the transferor U.S. shareholder might be eligible for the section 245A DRD.

To address these concerns, the temporary regs limit the amount of section 245A DRD allowed to a CSTS. The DRD limit is the portion of the dividend that is paid out of E&P other than the ER amount.

A CSTS may prefer an income inclusion under GILTI because it will benefit from the section 250 deduction. Therefore the temporary regs provide an election in which the CSTS is not required to reduce its section 245A DRD if it elects to close the CFC’s tax year for all purposes on the date of the ER.

Examples

Section 1.245A-5T(j) contains six examples that illustrate how EDs and ERs reduce the DRD. The first two examples explain the ED, while the last four show how the ER rules work. In all four ER examples (unless otherwise indicated):

  • US1 and US2 are unrelated domestic corporations with calendar tax years;

  • CFC1 and CFC2 are SFCs that are also CFCs;

  • absent the regs, dividends received by US1 and US2 would qualify for the section 245A DRD; and

  • the de minimis rules do not apply.

Moreover, all four ER examples assume that no person transferred CFC stock in the prior year under a plan to reduce the percentage of CFC stock value owned by a CSTS.

Example 3 describes an ER and its results. At the beginning of the year, US1 owns all stock of CFC1 and has no ED account. At the end of the year, CFC1 has no section 959(c)(1) or (2) E&P but does have $160 of tested income (and E&P).

On October 19, US1 sells all its CFC1 stock to US2 for $100 and recognizes $90 of gain, which is included in US1’s gross income as a dividend eligible for the section 245A DRD under section 1248. (See Figure 1.)

Figure 1. Reg. Section 1.245A-5T(j), Example 3

At the end of the year, US2 has $70 of tested income calculated as $160 minus the $90 gain described in section 951(a)(2)(B). This is the lesser of $90 (the dividend from the stock transfer) and $128, the amount of tested income attributed to the stock transfer, or $160 multiplied by 292/365, the fraction of days in the year that US2 did not own the CFC1 stock. US1 did not elect to close CFC1’s tax year as of the end of October 19, the date the sale occurred.

US1 is a CSTS of CFC1, and the stock sale is an ER because both conditions are met:

  • US1 transferred 100 percent of its CFC1 stock, which is more than 5 percent of the CFC1 stock value US1 owned at the beginning of the year; and

  • on the last day of the year, the percentage of the CFC1 stock value owned by US1 (0 percent) is less than 90 percent of the value owned by US1 on the day of the year it owned its highest percentage (100 percent).

There were no transactions in the prior year under a plan to reduce US1’s ownership percentage, and the difference between the initial percentage and end-of-year percentage is at least 5 percentage points.

The entire $90 dividend is an ER for US1 because the dividend is at least equal to US1’s pre-reduction pro rata share of CFC1’s tested income ($160), reduced by the amount of tested income taken into account by US2, a U.S. tax resident ($70). The ineligible amount is $90, the sum of 50 percent of any ED amount ($0) and the ER. No portion of the $90 is eligible for the section 245A DRD. (See Table 1.)

If US1 elects to close CFC1’s tax year at the end of October 19, and US1 and US2 agree that US1 will elect to do so, US1 takes into account 100 percent of CFC1’s $160 tested income for the tax year beginning January 1 and ending October 19. No amount is considered an ER.

Table 1. Limit on DRD

 

 

US1

US2

Total

a.

Gain/dividend

$90

N/A

$90

b.

951(a)(2)(B) amount ($90 < $128)

N/A

$90

$90

c.

Tested income

$90

$70

$160

d.

Pre-reduction pro rata share

$160

$0

$160

e.

ER amount ($160 - $70)

$90

N/A

$90

f.

245A DRD (a - e)

$0

N/A

$0

Example 4 shows how a section 245A shareholder’s pre-reduction pro rata share is decreased for amounts that are included in income by U.S. tax residents. CFC1 generates $120 of subpart F income and no tested income during the year. On October 1, CFC1 distributes a $120 dividend to US1. On October 19, US1 sells 100 percent of its CFC1 stock to domestic partnership PRS and recognizes no gain or loss. PRS is owned 50 percent each by individual A, who is a U.S. citizen, and individual B, who is not a U.S. citizen or resident.

On December 1, US2 and FP (a foreign corporation) both contribute property to CFC1 in exchange for 25 percent of CFC1 stock, and PRS continues to own the remaining 50 percent. US1 does not elect to close CFC1’s tax year. (See Figure 2.)

Figure 2. Reg. Section 1.245A-5T(j), Example 4

As in Example 3, US1 is a CSTS and the stock sale causes an ER because both conditions are met:

  • US1 transferred 100 percent of its CFC stock, which is more than 5 percent of total CFC1 stock value; and

  • on the last day of the year, the percentage of CFC1 stock US1 owns at the end of the year (0 percent) is less than 90 percent of the highest percent US1 owned during the year (initial 100 percent) and the difference between them is at least 5 percentage points.

Before the ER, US1 owned 100 percent of the CFC1 stock, so the tentative amount of US1’s pre-reduction pro rata share of CFC1’s subpart F income is $120. A and US2 are U.S. tax residents that acquired CFC1 stock from US1 during the year the ER occurs, however, so US1’s pre-reduction pro rata share can be decreased. The reduction equals the amount of subpart F income taken into account under section 951(a) by the U.S. tax residents.

On December 31 of year 2, both PRS and US2 will be U.S. shareholders of CFC1 and will include in gross income their pro rata shares of CFC1’s subpart F income. US2’s share is $30 (25 percent of $120) and PRS’s share is $60 (50 percent of $120). PRS’s pro rata share will be reduced to $12 under section 951(a)(2)(B) by $48, which is the lesser of the $120 dividend paid to US1, and 50 percent of $120 multiplied by 292/365, the fraction of the year that PRS did not own CFC1 stock.

PRS includes $12 in gross income under section 951(a), of which $6 is allocated to partner A. A and US2 take into account a total of $36 of CFC1’s subpart F income, which reduces US1’s pre-reduction pro rata share of CFC1’s subpart F income to $84 ($120 - $36). CFC1 did not generate tested income during the year and so there is no reduction for section 951A income included by U.S. tax residents.

The ER amount is $84, or the lesser of the $120 dividend and the sum of US1’s pre-reduction share of CFC’s subpart F income ($84) plus tested income ($0). The ineligible amount is also $84, or 50 percent of any ED amount ($0) and the ER. Of US1’s $120 dividend, $36 is eligible for the section 245A DRD. (See Table 2.)

Table 2. Decrease in Pre-Reduction Pro Rata Share

 

U.S. Tax Residents

US1

A

US2

a.

Pre-reduction pro rata share

$120

N/A

N/A

b.

Reduction for inclusions

$36

$6

$30

c.

ER amount (a - b)

$84

N/A

N/A

d.

245A DRD (a - c)

$36

N/A

N/A

Example 5 clarifies the definition of a CSTS. US1 and US2 own 30 and 25 percent of CFC1’s stock, respectively. FP, a foreign corporation that is not a CFC, owns all stock of US1 and US2 plus the remaining 45 percent of CFC1 stock. On September 30 of year 2, US1 sells all its CFC1 stock to US3, a domestic corporation not related to FP, US1, or US2.

Because US1 and its related parties (US2 and FP) own more than 50 percent of CFC1’s stock, US1 is a CSTS of CFC1, which is an SFC. The sale of US1’s CFC1 stock is an ER because both conditions are met:

  • US1 transferred 100 percent of its 30 percent share, which is more than 5 percent of the total CFC1 stock value;

  • on the last day of the year, US1 owns 0 percent, which is less than 90 percent of the stock that it owned during the year (30 percent) and the difference between 30 and 0 percent is at least 5 percentage points.

Finally, Example 6 addresses the limit on the section 954(c)(6) FPHCI exception when there is a tiered ER. At the beginning of the year, US1 and A, a U.S. citizen, own 80 percent and 20 percent of CFC1 stock, respectively, and CFC1 wholly owns the stock of CFC2. US1 and A are U.S. shareholders of both CFC1 and CFC2 and are not related to each other.

At the end of the year, CFC2 had $150 of tested income and CFC1 had no income or expenses. On June 30, CFC2 distributed a $150 dividend to CFC1 that would qualify for the FPHCI exception but for the section 245A temporary regulations. On August 7, CFC1 sells all its CFC2 stock to US2 for $100 and realizes no gain or loss. (See Figure 3.)

Figure 3. Reg. Section 1.245A-5T(j), Example 6

At the end of the year, US2 takes into account $60 of tested income under section 951A, which is $150 minus $90 — that is, the lesser of $150 dividend and $90, the amount of tested income attributed to the transferred stock, or $150 multiplied by 219/365, the fraction of the year that US2 did not own the CFC2 stock . US1 does not elect to close CFC2’s tax year.

US1 is a CSTS of CFC2 but A is not. The stock sale causes an ER of US1’s ownership of CFC2, because both conditions are met:

  • US1 transferred indirectly 100 percent of the CFC stock it owned at the beginning of the year, which is more than 5 percent of the stock’s total value; and

  • the percentage of stock value US1 owned at the end of the year (0 percent) is less than 90 percent of its highest percentage of stock ownership during the year (80 percent), and the difference is at least 5 percentage points.

Because there is an ER related to CFC2 and CFC1 received a dividend from CFC2, there is a limit to the dividend amount eligible for the FPHCI exception in section 954(c)(6). The sum of subpart F income and CFC2 tested income for the year is $150, and before the ER, CFC1 owned 100 percent of the stock of CFC2. US2 is a U.S. tax resident and has a $60 pro rata share of CFC2’s tested income. The tiered ER is $90, or 100 percent of the $150 dividend minus US2’s $60 portion.

The portion of the $150 dividend eligible for the FPHCI exception is $60, or the $150 dividend minus the $90-tiered ER. The $90 that does not qualify for the FPHCI exception, is treated as subpart F income to CFC1. US1 and A will take into account their pro rata shares of that subpart F income. (See Table 3.)

Table 3. Limit on FPHCI Exception

 

 

US1

US2

a.

Dividend

$150

N/A

b.

951(a)(2)(B) amount ($90 < $150)

N/A

$90

c.

Tested income

$90

$60

d.

Tiered ER ($150 - $60)

$90

N/A

e.

FPCHI exception (a - d)

N/A

$60

Correction, August 12, 2019: Figure 3 has been changed to correct mislabeled boxes.

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