Target the Concerns Posed by Ownership Attribution Regs, Firm Says

November 20, 2020

The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Comments on Proposed Regulations Limiting the Scope of Section 954(c)(6) (REG-110059-20)

Dear Sirs:

We offer the following comment related to the proposed regulations under section 954(c)(6)¹ issued by the Department of the Treasury (the “Treasury”) and the Internal Revenue Service (the “IRS”) (the “Proposed Regulations”).² Specifically, this letter addresses the request for comments in the preamble to the Proposed Regulations as to whether and to what extent the section 954(c)(6) exception should apply to payments by a foreign corporation that is a controlled foreign corporation (“CFC”) solely by reason of downward attribution under section 318(a)(3) (a “New CFC”) but has a United States shareholder that owns stock of the CFC within the meaning of section 958(a) (a “section 958(a) U.S. shareholder”) and therefore is partially subject to U.S. taxing jurisdiction. We address a subset of the fact patterns implicated by that request for comments and recommend that, rather than the broad approach taken by the Proposed Regulations, regulations be issued that more narrowly address the concerns at which the Proposed Regulations are targeted and, in particular, preserve the application of section 954(c)(6) look-through, to the extent provided in the statute, to payments to New CFCs that do not have a section 958(a) U.S. shareholder that is related to the New CFC within the meaning of section 954(d)(3).

Background

Section 951(a) generally requires a United States shareholder of a CFC to include in its gross income its pro rata share (based on direct and indirect ownership) of the subpart F income of the CFC. Because a shareholder's pro rata share is determined based on direct and indirect ownership, only section 958(a) U.S. shareholders have subpart F inclusions, though other United States persons may be treated as United States shareholders through constructive ownership for purposes of determining CFC status, as explained below. Subpart F income includes, among other categories, foreign personal holding company income (“FPHCI”),³ which includes certain passive types of income, such as dividends, interest, rents, and royalties.⁴

A number of exceptions are provided that prevent certain income that would otherwise be FPHCI from being considered FPHCI. One such exception is section 954(c)(6). Section 954(c)(6) generally provides that dividends, interest, rents, and royalties received by a CFC from a related CFC are not treated as FPHCI to the extent the income is attributable or properly allocable to income of the payor CFC that is neither subpart F income nor income effectively connected with a trade or business in the United States. In other words, the provision generally allows the recipient CFC to “look through” to the classification of the income in the hands of the related payor CFC. The Secretary is instructed to “prescribe such regulations as may be necessary or appropriate to carry out this paragraph, including such regulations as may be necessary or appropriate to prevent the abuse of the purposes of this paragraph.”⁵

Section 954(c)(6) was enacted as part of the Tax Increase Prevention and Reconciliation Act of 2005. ⁶ The limited legislative history reflects that Congress recognized that “[m]ost countries allow their companies to redeploy active foreign earnings with no additional tax burden” and intended the exception to place U.S. companies on more equal competitive footing with foreign companies.⁷

Repeal of Section 958(b)(4)

Section 958 contains rules for measuring stock ownership for purposes of determining, among other things, whether a foreign corporation is a CFC. Section 958(a) details direct and indirect ownership rules, and section 958(b) provides rules regarding constructive ownership, which generally incorporate the provisions of section 318(a). Section 318(a) includes certain attribution rules that can cause a person to be treated as owning an interest in an entity greater than its direct or indirect interest. In particular, section 318(a)(3)(C) provides that “[i]f 50 percent or more in value of the stock in a corporation is owned, directly or indirectly, by or for any person, such corporation shall be considered as owning the stock owned, directly or indirectly, by or for such person.” In other words, a corporation is treated as owning stock owned by its fifty-percent or greater owner. A similar rule treats a partnership as owning stock owned by a partner.⁸ This attribution of ownership of stock actually owned by a shareholder or partner to the corporation or partnership is often referred to as “downward attribution.”

Prior to enactment of the Tax Cuts and Jobs Act (the “TCJA”),⁹ downward attribution from a foreign person did not apply for purposes of section 958. Section 958(b)(4) then provided that section 318(a)(3) “shall not be applied so as to consider a United States person as owning stock which is owned by a person who is not a United States person.”

The TCJA repealed section 958(b)(4). Congress's stated reason was “to render ineffective certain transactions that are used as a means of avoiding the subpart F provisions.” ¹⁰ In particular, the repeal was targeted at de-control transactions that would convert a CFC to a non-CFC by shifting ownership within a controlled group, notwithstanding continuing non-controlling ownership by U.S. shareholders within the group.¹¹ The legislative history indicates that the repeal of section 958(b)(4) was “not intended to cause a foreign corporation to be treated as a controlled foreign corporation with respect to a U.S. shareholder as a result of attribution of ownership under section 318(a)(3) to a U.S. person that is not a related person (within the meaning of section 954(d)(3)) to such U.S. shareholder as a result of the repeal of section 958(b)(4).”¹² However, to date Treasury and the IRS have not issued guidance applying section 958 consistent with this intent.

Proposed Regulations Under Section 954(c)(6)

Since the enactment of the TCJA, Treasury and the IRS have issued guidance under a number of provisions to generally preserve the scope of such provisions as they applied prior to the repeal of section 958(b)(4). In particular, on October 2, 2019, Treasury and the IRS proposed regulations that added or modified regulations under a broad range of Code sections whose provisions involved the concept of a CFC, in response to the repeal of section 958(b)(4).¹³ The affected sections included section 267(a)(3)(B)(i), section 332(d), section 672(f), section 706, section 863(d) and (e), section 904, and section 1297(e). Under those proposed regulations, the pre-TCJA scope of the provisions generally was restored by determining CFC status for purposes of the particular provisions without downward attribution from a foreign person to a U.S. person, consistent with the operation of section 958(b)(4) prior to its repeal. Those proposed regulations were finalized, with certain changes, on September 22, 2020.¹⁴

Also on September 22, 2020, Treasury and the IRS released the Proposed Regulations under section 954(c)(6). The Proposed Regulations restrict the application of section 954(c)(6) so that it only applies to amounts received from a CFC that would be a CFC without regard to downward attribution (a “Historic CFC”).¹⁵ The preamble to the Proposed Regulations notes generally that, “[c]onsistent with the purpose underlying the 2019 proposed regulations, these proposed regulations propose additional changes that are intended to ensure that certain rules under sections 367(a) and 954(c)(6) apply in the same manner in which they applied before the repeal of section 958(b)(4).”

The preamble to the Proposed Regulations references the legislative history of section 954(c)(6) and concludes that “the section 954(c)(6) exception is intended to apply to payments between CFCs of a U.S.-based multinational group that have active foreign earnings that are subject to the subpart F provisions.” ¹⁶ It then posits that payments made by a New CFC to a Historic CFC should not be eligible for the section 954(c)(6) exception, because “most or all of [a New CFC]'s earnings typically are not under U.S. taxing jurisdiction.”¹⁷

The preamble to the Proposed Regulations does not analyze the effect of this limitation in cases in which a New CFC has a section 958(a) U.S. shareholder. The preamble requests comments “as to whether, and if so, to what extent, the section 954(c)(6) exception should be available in cases in which a related foreign payor corporation (that is a CFC solely as a result of downward attribution) has section 958(a) U.S. shareholders and therefore is partially under U.S. taxing jurisdiction.”¹⁸

Analysis of Selected Fact Patterns

For purposes of analyzing the proper scope of the section 954(c)(6) exception, it is useful to analyze certain fact patterns that may be implicated. Set out below is an illustrative diagram for this purpose.

In the above illustrative structure, each of CFC1, CFC2, and CFC3 is a New CFC as a result of downward attribution of ownership from Foreign Parent to USCo. CFC4, which is wholly owned by USCo, is a Historic CFC. Accordingly, under the Proposed Regulations, payments from CFC4 to any of the other CFCs in the Foreign Parent Group would be eligible for section 954(c)(6) look-through treatment to the extent relevant, but no payments from CFC1, CFC2, or CFC3 to any of those CFCs or to CFC4 would be eligible for section 954(c)(6) look-through treatment to any extent.

The preamble to the Proposed Regulations indicates that Treasury and the IRS's fundamental concern is that payments made to a Historic CFC by a New CFC should not qualify for section 954(c)(6) look-through. In the above structure, that would implicate payments made to CFC4 by any of the other CFCs. This position is understandable because applying section 954(c)(6) to such payments would convert them from payments generating taxable subpart F income pre-TCJA to payments that are now eligible for section 954(c)(6) look-through treatment. With respect to this fact pattern, the Proposed Regulations merely preserve the pre-TCJA results of the relevant transactions.

However, the Proposed Regulations would also disqualify payments between CFC1, CFC2, and CFC3 from look-through treatment. Prior to the TCJA, none of these foreign corporations would have been CFCs. Consistent with the TCJA legislative history, it would be most appropriate not to subject U.S. Investor to U.S. tax under subpart F on the earnings of these foreign corporations at all, in which case the Proposed Regulations would not generally be relevant to payments between these foreign corporations. However, treating these foreign corporations as CFCs with respect to U.S. Investor means that U.S. Investor will now be subject to U.S. tax on a portion of all of the passive income of these entities. The Proposed Regulations would go even further and override the statutory language of section 954(c)(6) to convert active income of CFC1, CFC2, and CFC3 into passive income subject to tax under subpart F as a result of routine payments between these entities. There does not appear to be a policy justification for such a rule.

The general principle that underpins the recently finalized regulations related to the repeal of section 958(b)(4) — that the pre-TCJA scope of relevant provisions should be preserved — would not support such a rule. Because the recipient foreign corporations would not have been CFCs prior to the TCJA, their income would not have been included by U.S. investor as subpart F income in any event. So turning off section 954(c)(6) with respect to such payments would upset the pre-TCJA result, in a way that Congress did not intend, rather than preserve it.

Similarly, the legislative history of section 954(c)(6) does not appear to support this result. The broad intent of section 954(c)(6), as evidenced by its effect, is to prevent the conversion of active income into passive income through specified routine payments within a controlled group. While the legislative history of the provision does reference the active foreign earnings of “U.S.” companies, this should not be read as indicating that look-through should only apply to payments by certain CFCs. At the time that section 954(c)(6) was enacted, the scope of all of subpart F was limited to CFCs controlled by section 958(a) U.S. shareholders, so Congress would have had no reason to describe the scope of the exception any more broadly. And even prior to the TCJA, section 954(c)(6) applied to payments within a foreign-parented multinational group if it were more than 50% owned by unrelated significant U.S. investors. Taking into account the new scope of the subpart F provisions post-TCJA, the principles expressed by Congress of conforming to international norms and not disfavoring U.S. investors are also applicable in the case of section 958(a) U.S. shareholders of New CFCs.

Moreover, the type of affirmative tax planning that might be implemented in reliance on the application of section 954(c)(6) to payments received by a Historic CFC, which is by definition controlled by section 958(a) U.S. shareholders (i.e., in the example, CFC4), is not likely to be undertaken in the context of payments to New CFCs that do not have related section 958(a) U.S. shareholders. In particular, CFC1, CFC2, and CFC3 in the above structure are controlled by Foreign Parent, and Foreign Parent is generally indifferent to the U.S. tax treatment of the income of such entities, because neither it nor any related party is a section 958(a) U.S. shareholder of such entities. U.S. Investor, the only section 958(a) U.S. shareholder with respect to these New CFCs, does not control the Foreign Parent group, and therefore cannot engage in tax planning based on the application of section 954(c)(6) to payments received by such entities. It would be anomalous and arbitrary to impose U.S. tax on U.S. Investor by treating payments between CFC1, CFC2, and CFC3 as subpart F income for no other reason than because U.S. Investor does not control Foreign Parent and the relevant CFCs (i.e., because they are New CFCs rather than Historic CFCs). In fact, this would turn the application of subpart F, which has always been targeted at preventing tax avoidance through the use of foreign corporations controlled by U.S. shareholders, on its head. Rather than taking the approach of the Proposed Regulations, any guidance issued should preserve the application of section 954(c)(6), to the extent provided in the statute, to payments between New CFCs that do not have a related section 958(a) U.S. shareholder.

It is also noteworthy that the Proposed Regulations would create disparate treatment of similarly situated taxpayers. Under the Proposed Regulations, if U.S. Investor in the above example owned 49% of Foreign Parent, it would be subject to U.S. tax on 49% of the payments between CFC1, CFC2, and CFC3 that would qualify for subpart F look-through treatment under the statute, but would generate subpart F income under the Proposed Regulations. If, on the other hand, U.S. Investor owned 51% of Foreign Parent, payments between CFC1, CFC2, and CFC3 (which would all now be Historic CFCs) would qualify for subpart F look-through treatment. These results are arbitrary and should be avoided in this context where there is no policy reason to depart from the statutory rule.

Finally, the preamble's request for comments on “the extent to which” section 954(c)(6) should apply to payments by New CFCs and the suggested relevance of the fact that “most or all of [a New CFC]'s earnings typically are not under U.S. taxing jurisdiction” should be addressed. There is no indication in the statute or relevant legislative history that application of section 954(c)(6) should depend on the portion of the payor CFC's earnings that are subject to U.S. taxing jurisdiction, other than the fact that the payor must be a CFC related to the CFC recipient. Section 954(c)(6) has always applied to the full amount of the payment from a CFC (regardless of precise ownership by section 958(a) U.S. shareholders) to a related CFC. Absent other potential considerations (such as generally preserving the treatment of payments that actually resulted in subpart F inclusions prior to the TCJA), there is no apparent reason why 50% U.S. ownership (as defined in section 958(a)) should be an absolute requirement for the application of subpart F look-through or a threshold below which a reduced portion of a payment is eligible for look-through treatment.

Suggested Rule

In light of the above, the Proposed Regulations, which deny section 954(c)(6) look-through treatment to any payments by New CFCs, should be replaced with a more targeted rule that addresses the concerns that Treasury and the IRS have with respect to affirmative tax planning made possible by the repeal of section 958(b)(4), without arbitrarily imposing additional U.S. tax on unrelated section 958(a) U.S. shareholders with respect to ordinary business transactions within a multinational group. Such rule should preserve the application of section 954(c)(6) to the extent provided by the statute to payments to a New CFC that does not have a section 958(a) U.S. shareholder that is related within the meaning of section 958(d)(3).

Thank you for your consideration. If you have any questions, please feel free to contact me.

Sincerely,

Aaron Payne
Eversheds Sutherland (US) LLP
Washington, DC

Cc:
William M. Paul
Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224