More Guidance Needed on Dividends Received by CFCs, Firm Says

April 14, 2020

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

Mr. Lafayette G. “Chip” Harter
Deputy Assistant Secretary for International Affairs
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

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

Re: Application of Section 245A to Dividends Received by CFCs

Dear Sirs:

We appreciate the opportunity to offer the following comment regarding the application of section 245A to dividends received by controlled foreign corporations (“CFCs”), as requested in the preamble to the final and temporary regulations under section 951A issued by the Department of the Treasury (the “Treasury”) and the Internal Revenue Service (the “IRS”) in June 2019.¹ Recent public statements by an IRS official indicate that the IRS would appreciate comments that more thoroughly address policy considerations such as the underlying principles of subpart F and the legislative intent motivating section 245A.² We therefore begin with a discussion of the history and purpose first of the subpart F provisions and then of section 245A, and explain that from a policy perspective it is clear that section 245A should apply to dividends received by CFCs for purposes of determining their subpart F income. We then examine Treasury and the IRS's authority under section 245A, as well as the legislative history thereof, to confirm that Treasury and the IRS have the authority to issue guidance applying section 245A to dividends received by CFCs, and explain that issuing contrary guidance would not be appropriate in light of such history, viewed in the context of the overarching policy considerations. In order to provide additional certainty to taxpayers, in light of questions that have arisen due to statements already made by Treasury and the IRS, we request that guidance be issued explicitly providing that section 245A applies to dividends received by CFCs from specified 10-percent owned foreign corporations (as defined in section 245A(b)) that are at least 10% owned (within the meaning of section 958(a) and (b)) by the CFC. Finally, we note that additional guidance should be issued to address the interaction of section 245A and other provisions, such as section 1059, to avoid unintended tax cost related to dividends to which section 245A applies.

The focus of this letter is the application of section 245A to dividends received by CFCs from non-controlled foreign corporations, which dividends are very significant for many taxpayers and represent the principal situation under current law where a failure to apply section 245A at the CFC level would lead to double taxation. However, in evaluating the application of section 245A to dividends received by CFCs it is important to also consider the implications for dividends from related CFCs after the scheduled expiration of the section 954(c)(6) look-through exception to subpart F income, which currently does not apply to taxable years of foreign corporations beginning after December 31, 2020.

Subpart F

Before 1962, the income of a foreign corporation, even one owned by a U.S. shareholder, generally was not subject to U.S. tax if the income was earned outside the United States and not repatriated as a dividend. As recounted in the legislative history of the Revenue Act of 1962, domestic taxpayers were therefore increasingly shifting profits to foreign subsidiaries located in “tax haven” countries and retaining the earnings in such subsidiaries to defer U.S. tax on the earnings until the money was repatriated.³ To curtail this practice, Congress added subpart F to the Code as part of the Revenue Act of 1962.⁴

The legislative effort that culminated with the enactment of subpart F began with a 1961 proposal by the Kennedy administration to eliminate “tax deferral privileges” with respect to most income earned through foreign corporations.⁵ Although the Kennedy administration's proposal applied to most income of foreign corporations, the target of the proposal was “artificial tax inducements to invest abroad” in the form of deferral of U.S. tax on the income generated.⁶ In enacting subpart F, Congress remained focused on this central issue, although it limited the scope of the provisions compared to what had been proposed by the Kennedy administration, tailoring the elimination of deferral more narrowly to address the “problem of diversion of income from U.S. taxation.”⁷

One of the critical objectives of subpart F (and the one most pertinent to the taxation of passive income, such as dividends) was to impose tax on “what could ordinarily be expected to be U.S. source income” but had been diverted to a foreign affiliate.⁸ To implement this objective, Congress created a grouping of income referred to as “subpart F income,” which was subject to current U.S. taxation when earned by a foreign subsidiary of a U.S. shareholder. Section 952 defined subpart F income to mean the sum of (i) income derived from the insurance of United States risks on property or persons, as defined in new section 953, and (ii) foreign base company income, as defined in new section 954. In general, this foreign base company income consisted of “income from passive sources — such as dividends, interest, rents, etc., and also certain income from sales subsidiaries”.⁹ Consistent with the overarching purpose of subpart F being to prevent the avoidance of U.S. tax by U.S. persons through the use of foreign corporations, the scope of the provisions was limited to CFCs, that is, foreign corporations deemed to be more than 50% controlled by material U.S. shareholders. The subpart F income was attributed to the “10-percent” U.S. shareholders and taxed to them largely in the same manner as dividends.

The subpart F provisions were tailored to preserve deferral for active foreign operations that were not structured to achieve a tax advantage, in order to avoid putting U.S.-owned businesses at a disadvantage compared to their foreign-owned peers. However, both the House and Senate reports note that a different view was taken with respect to passive income, stating: “In such cases there is no competitive problem justifying postponement of the tax until the income is repatriated.”¹⁰ Here and throughout the House and Senate reports, and particularly with respect to passive income, it is clear that the purpose of the subpart F provisions is to prevent the deferral of U.S. tax on certain income that would have been subject to U.S. tax if earned directly by a United States shareholder.¹¹ Nowhere in the House, Senate, or Conference¹² reports, nor anywhere else in the legislative history, is there any suggestion that Congress intended to tax income under subpart F that would not have been subject to tax if earned by a U.S. corporation.

Restricting the scope of subpart F to income that would be taxable if earned by a U.S. corporation was the logical approach, not only because Congress's anti-tax-avoidance objectives did not require that the scope of subpart F be extended further, but also because taxing income under subpart F that would not be taxable if earned in the U.S. would have been contrary to two other significant and related policies motivating the enactment of subpart F. The first such policy was to promote equity among U.S. taxpayers, by eliminating the benefit of deferral for taxpayers who made investments through foreign subsidiaries that could just as well be made directly by the U.S. taxpayer.¹³ The other such policy was to encourage economic efficiency by promoting tax neutrality.¹⁴ Both of these policies are advanced by taxing foreign subsidiary income that would be subject to tax if earned in the U.S., but if subpart F imposed tax on a CFC's income that would not be subject to tax if that income were earned directly by the CFC's owner, such imposition would be directly contrary to these policies.¹⁵

Section 245A

The Tax Cuts and Jobs Act (“TCJA”)¹⁶ substantially altered the U.S. system of taxation of foreign subsidiaries, while preserving the taxation and general parameters of subpart F income. As a cornerstone of the shift closer to a “territorial system,” the TCJA added new section 245A to the Code, which generally allows a domestic corporation that is a United States shareholder of a specified 10-percent owned foreign corporation a 100 percent dividends received deduction (“DRD”) for the foreign-source portion of dividends received from the foreign corporation. “United States shareholder” is defined in section 951(b) to include any U.S. person that owns 10 percent or more of the total combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a foreign corporation. “Specified 10-percent owned foreign corporation” is generally defined as any foreign corporation with respect to which a domestic corporation is a United States shareholder.¹⁷ Section 246 imposes certain restrictions on the availability of deductions under section 245A, including imposing a one-year holding period requirement. Section 245A(e) denies the section 245A DRD with respect to a hybrid dividend, which is generally a dividend received from a CFC for which the section 245A DRD would otherwise be allowed and for which the distributing CFC received a deduction with respect to any foreign income taxes.

As described in the TCJA Conference Report, section 245A “allows an exemption for certain foreign income by means of a 100-percent deduction for the foreign-source portion of dividends received. . . .”¹⁸ The House Committee on Ways and Means Report accompanying the initial draft of the bill explains that the Committee felt that the historic system for taxing foreign earnings put American companies and workers at a disadvantage, primarily because the worldwide system of taxation with deferral created perverse incentives to retain funds offshore. The Committee believed that a territorial system with a lower corporate tax rate would “make American workers and companies competitive again, and also [would] remove tax-driven incentives to keep funds offshore.”¹⁹ The Senate Finance Committee explanation of the bill stated, in a similar vein:

In a territorial system, income earned outside the United States is not taxed in the United States. In this provision, this is accomplished by means of a deduction for the U.S. portion of dividends received by U.S. corporations from foreign affiliates.

The provision would allow U.S. companies to compete on a more level playing field against foreign multinationals when selling products and services abroad by eliminating an additional level of tax.

The provision would eliminate the “lock-out” effect under current law, which means U.S. businesses avoid bringing their foreign earnings back into the United States to avoid the U.S. residual tax on those earnings.²⁰

Policy Considerations Regarding the Application of Section 245A at the CFC Level

The statute makes clear that the exemption provided by section 245A applies to dividends received directly by a domestic corporate United States shareholder from controlled foreign subsidiaries and 10%-owned foreign corporations that are not controlled by one or more United States shareholders. However, the statute does not explicitly extend this treatment to such dividends received by CFCs. Nonetheless, in light of Congress's policy choices in enacting subpart F and section 245A, discussed above, it is apparent that section 245A ought, from a policy perspective, to apply to a dividend received by a CFC for purposes of determining that CFC's taxable income for purposes of calculating subpart F income.²¹ As explained in the following section, the legislative history of the TCJA and various technical considerations further support the appropriateness of this result as a matter of statutory interpretation.

As discussed above, the legislative history related to the original enactment of subpart F clearly demonstrates that Congress subjected passive income such as dividends to current taxation under subpart F to prevent the deferral of U.S. tax with respect to income that would have been currently taxed if earned directly in the United States. The policies underlying subpart F, therefore, do not suggest that dividends that would be exempt from U.S. tax by operation of section 245A if received by a U.S. corporation should be subject to U.S. tax under subpart F if received by a CFC. In fact, the policies of equity and efficiency that partially motivated the enactment of subpart F would counsel against such a result.

Likewise, the policies underlying section 245A do not suggest that the section 245A DRD's application should be limited to dividends received by U.S. corporations rather than CFCs. The articulated policies noted above — consistency with a territorial system, enhancement of American competitiveness, and eliminating the lock-out effect of prior law — do not depend on whether a US taxpayer holds its investment in a foreign company directly or through a foreign subsidiary. As regards dividends from non-CFCs in particular, Congress made the policy decision to exempt dividends from 10%-owned foreign corporations by including them within the scope of section 245A, and there is no policy reason why such exemption should be conditional on the stock being held directly by a US shareholder.

If dividends from non-controlled 10%-owned foreign corporations, or even CFCs, are not eligible for the section 245A DRD at the level of a CFC recipient, this would force taxpayers to transfer ownership of such entities to a U.S. corporation in order to avoid full double taxation. Such transfers are liable to incur significant U.S. tax, foreign tax, or both, resulting in inefficiencies and competitive disadvantage to U.S. multinational groups that hold such investments through CFCs for historical reasons. These results would be directly contrary to the policies intended to be advanced by both subpart F and section 245A.²²

In sum, from a policy perspective it is clear that section 245A should apply to qualifying dividends received by CFCs for purposes of determining their subpart F income.

Technical Considerations Regarding the Application of Section 245A at the CFC Level

Section 245A(g) provides that the Secretary shall issue guidance necessary or appropriate to carry out the provisions of section 245A. Accordingly, Treasury and the IRS clearly have the authority to issue guidance furthering the above policy objectives by providing that section 245A applies for purposes of determining a CFC's taxable income. Moreover, such guidance would effect the clearly expressed legislative intent, as reflected both in the TCJA Committee Report and other provisions of the TCJA.

Although section 245A by its literal terms applies only to dividends received by a domestic corporation, Congress expressed the understanding and intention that section 245A would apply to dividends received by CFCs. Footnote 1486 of the TCJA Conference Report explains that the statutory reference to a dividend received by a domestic corporation includes a dividend received by “a controlled foreign corporation treated as a domestic corporation for purposes of computing the taxable income thereof. See Treas. Reg. sec. 1.952–2(b)(1). Therefore, a CFC receiving a dividend from a 10-percent owned foreign corporation that constitutes subpart F income may be eligible for the DRD with respect to such income.”²³ The cited regulation generally provides that the taxable income of a foreign corporation shall be determined “by treating such foreign corporation as a domestic corporation taxable under section 11 and by applying the principles of section 63.”²⁴ The footnote clearly articulates that Congress understood and intended that section 245A would apply for purposes of calculating the taxable income of a CFC.

Such intention is also apparent from other provisions of the TCJA. As referenced above, section 245A(e)(4) generally defines a “hybrid dividend” as a dividend from a distributing CFC for which the recipient would otherwise be allowed a section 245A DRD and for which the distributing CFC received a deduction with respect to any foreign income taxes. Section 245A(e)(2) provides special rules treating hybrid dividends that are received by CFCs as subpart F income. Because a hybrid dividend is by definition a dividend to which the section 245A DRD would otherwise apply, the reference to hybrid dividends received by CFCs confirms that Congress intended section 245A to apply at the CFC level.²⁵ Similarly, section 964(e)(4)(B), as enacted by the TCJA, provides that rules similar to the rules of section 961(d) apply to a sale by a CFC of stock in another foreign corporation. Section 961(d) generally requires that a selling shareholder reduce its basis in the stock of a foreign corporation, for purposes of determining any loss on the sale of such stock, by the amount of any section 245A DRD that was allowable to such shareholder. Application of rules similar to section 961(d) in the context of section 964(e), which can only apply to a sale of stock by a CFC, again confirms that Congress intended the section 245A DRD to be allowed to CFCs.

The outright repeal of the indirect foreign tax credit under section 902 is also instructive in this regard. The TCJA House Report explains that section 902 was repealed because it was no longer needed to avoid double taxation of income since dividends from 10%-owned foreign corporations are exempt under section 245A going forward, stating such a “credit is not appropriate in a participation exemption system under which 100 percent of dividends received by certain domestic corporate shareholders of specified foreign corporations are exempt from U.S. taxation.”²⁶ There is no indication that Congress intended, by repealing section 902, to subject dividends received by CFCs from foreign 10%-owned non-CFCs to full double taxation (or dividends received by CFCs from related CFCs after the expiration of the temporary look-through provision of section 954(c)(6)). Rather, such a result would be inconsistent with the policies behind section 245A and have the opposite result from that which Congress intended.²⁷ It is not plausible that Congress deliberately enacted such a fundamental change, which would result in full double taxation of certain foreign earnings, without explanation or comment.

Under general principles of statutory construction, section 245A should be interpreted and applied in a manner that gives meaning to the other TCJA provisions described above.²⁸ This is particularly true considering that Congress, in the Conference Report, made explicit its understanding that under the applicable regulations section 245A would apply at the CFC level, notwithstanding the statutory reference to dividends received by a domestic corporation. Taking this specific Congressional direction into account, in addition to the directly relevant and compelling policy considerations discussed above, and in light of the other related statutory provisions that require that section 245A apply to a dividend to a CFC in order for them to apply as intended, there can be no doubt that Treasury and the IRS have the authority to issue guidance explicitly providing that section 245A applies to dividends received by CFCs.²⁹ Moreover, in light of the Congressional pronouncements, both broad and specific, discussed above, it would not be appropriate for Treasury and the IRS to issue contrary guidance. In order to provide additional certainty to taxpayers, in light of questions that have arisen due to statements already made by Treasury and the IRS, we request that guidance be issued explicitly providing that section 245A applies to dividends received by CFCs from specified 10-percent owned foreign corporations (as defined in section 245A(b)) that are at least 10% owned (within the meaning of section 958(a) and (b)) by the CFC.

Additional Guidance Related to the Interaction of Sections 245A with Other Provisions

As has been discussed in other comment letters, guidance is needed to coordinate the application of section 245A with other sections of the Code. In particular, guidance should provide that dividends that are excluded from personal holding company income pursuant to section 954(c)(3) and (c)(6) and dividends that are excluded from gross income of a CFC for purposes of section 951(a) pursuant to section 959(b) are not dividends with respect to which a deduction is allowable under section 245A for purposes of section 1059, which would result in an inappropriate reduction of basis pursuant to section 1059.³⁰

If you have any questions, please feel free to contact us.

Sincerely,

Cliff Muller and Aaron Payne
Eversheds Sutherland (US) LLP
Washington, DC

Cc:
Douglas L. Poms
International Tax Counsel
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Brenda Zent
Special Advisor to the International Tax Counsel
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Peter Blessing
Associate Chief Counsel (International)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Laura Williams, Chief, Branch 4
Office of Associate Chief Counsel (International)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Robert Williams, Jr., Branch 4
Office of Associate Chief Counsel (International)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Logan M. Kincheloe, Branch 4
Office of Associate Chief Counsel (International)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224