Both the House and Senate versions of bills that would become the Tax Cuts and Jobs Act (P.L. 115-97) proposed repealing for corporate shareholders the application of section 956 — which, in conjunction with section 951(a)(1)(B), generally requires U.S. shareholders of controlled foreign corporations with investments in U.S. property to include a corresponding amount in current income. (For the Joint Committee on Taxation’s comparison of the bills, see JCX-64-17.)
Following enactment of the TCJA, there’s not much use for a provision that ensures that U.S. shareholders of CFCs are fully subject to U.S. tax when they indirectly access foreign earnings if the CFC invests in specific types of property. Now that CFCs can distribute earnings tax free via an actual dividend to U.S. corporate shareholders, subjecting those shareholders to full U.S. tax because of a CFC’s investments in U.S. assets doesn’t make a lot of sense. Even so, the conference report version of the bill that was finally enacted retained section 956 without modification.
It seems Treasury was dissatisfied with that approach. On October 31, in far-reaching regulations (REG-114540-18), it went back to 1960s legislative history to examine the reason for section 956. Concluding that the provision is mostly irrelevant if actual dividends are eligible for a 100 percent dividends received deduction (section 245A), Treasury drastically narrowed the scope of section 956 so that it generally no longer applies to require U.S. corporate shareholders to include in income an amount based on a CFC’s investments in U.S. property (the story is different for individual shareholders). While Treasury grounded its proposed regulations firmly in legislative history, it presumably was also responding to concerns that post-TCJA, taxpayers were using section 956 as a planning tool to access foreign tax credits.
Treasury’s radical move in eviscerating section 956 for corporate groups is important because it will change the structure of many third-party lending arrangements for which section 956 restricted the use of CFC stock as collateral. It also may act as a guide for Treasury’s plans for TCJA regulations more generally. After all, if Treasury feels free to use its regulatory authority to mostly remove a provision from the code because it thinks the legislative purpose is no longer relevant, other code sections might be in line for similar treatment.
Section 956 — A Primer
Section 951(a)(1)(B) requires a U.S. shareholder of a CFC to generally include in income the amount determined under section 956. That amount is based on the CFC’s investment in U.S. property during the tax year, limited by its earnings and profits. Section 956 was enacted in 1962 — at the same time as the subpart F rules — and, according to the legislative history as quoted in the preamble to the proposed regulations, was intended “to prevent the repatriation of income to the United States in a manner which does not subject it to U.S. taxation” (see H.R. Rep. No. 1447 (1962), at 58). The determination of the section 956 amount by reference to the CFC’s investment in U.S. property was intended to mimic the tax treatment of an actual dividend, because those investments were considered “substantially the equivalent of a dividend” (see S. Rep. No. 1881 (1962), at 88).
As with many antiabuse rules, taxpayers found ways to use section 956 to their advantage. Because the section 956 inclusion was treated as a dividend for allowing taxpayers to repatriate an attributable portion of foreign taxes paid by the relevant CFC under section 960, taxpayers could plan in such a way to ensure that a small section 956 inclusion would carry with it large FTCs. In response to concerns about that, Treasury and the IRS put layers of antiabuse provisions in the section 956 regulations under the broad authority granted in section 956(e).
In November 2016 the government used that authority to issue regulations (T.D. 9792) expanding the scope of the antiabuse rule in the section 956 regs. Reg. section 1.956-1T(b)(4) was intended to ensure that taxpayers couldn’t avoid the application of section 956 by having a CFC with no E&P acquire U.S. property from another CFC with E&P (that would otherwise trigger an inclusion under section 951(a)(1)(B)). But it turned out that the antiabuse rule wasn’t broad enough to combat taxpayers’ creative planning, so the 2016 regulations further expanded it.
In short, a rule originally enacted by Congress to ensure current U.S. taxation of some types of investments of foreign earnings resulted in a web of complexity. Recognizing that it might no longer be necessary, given the enactment of a participation exemption, could eliminate some of that complexity. It could also remove tax-induced inefficiencies in credit agreements, many of which restricted creditors’ ability to access the type of loan collateral otherwise desired (because a pledge of CFC stock, generally requested in a loan agreement, could give rise to a section 956 inclusion).
Planning Concerns
With the repeal of section 902, U.S. corporate shareholders of foreign corporations can no longer claim an indirect FTC when that corporation pays a dividend. Post-TCJA, the only mechanism for claiming FTCs for foreign taxes paid by a corporate subsidiary is in section 960, which allows corporate shareholders to claim an indirect credit for inclusions of subpart F income (under section 951(a)(1)(A)), global intangible low-taxed income (under section 951A), and section 951(a)(1)(B) income (stemming from a CFC’s investments in U.S. property). Subpart F and GILTI inclusions are from a CFC’s current-year earnings and generally allow shareholders to claim FTCs only for taxes paid by a CFC in the same year as the inclusion. Section 956 inclusions are thus the only mechanism allowing a U.S. shareholder to claim a credit for foreign taxes paid by a CFC in a year other than the year of inclusion. In short, the planning opportunities of section 956 — originally intended to ensure current U.S. tax on otherwise deferred earnings — may have been expanded at the same time that the overall purpose of the regime was significantly altered.
It’s far from anomalous for an international tax provision originally intended as an antiabuse rule to morph into a tax planning opportunity. A prime example is section 1248. Originally enacted to achieve uniformity in the taxation of actual dividends from CFCs and the gain considered attributable to accumulated E&P on the sale of a CFC’s stock, the provision eventually turned into an effective tax planning tool that allowed taxpayers to access FTCs in connection with dispositions of CFC stock. But it’s unclear how effective a planning tool section 956 would have been if left unchanged, given GILTI’s reach in subjecting U.S. shareholders to current tax on CFC earnings and the interaction of the ordering rules for GILTI, subpart F, and section 956 inclusions.
Rewriting Section 956
The proposed regulations essentially turn off the application of section 956 for corporate U.S. shareholders of CFCs by providing that the amount otherwise determined under that section is reduced if the shareholder would be allowed a deduction under section 245A if it had received a dividend of that amount. In short, the proposed regs do what the House and Senate bills would have done: turn off section 956 for corporate shareholders (although they don’t mention those legislative proposals, or the conference bill’s ultimate rejection of that change).
That tax-free treatment is denied if section 245A(e) — which turns off the dividends received deduction for hybrid dividends — would otherwise apply to the hypothetical dividend. That anti-hybrid rule applies not only when hybrid instruments are held directly by U.S. shareholders of CFCs, but also when any entity in the chain of CFC ownership that’s capitalized with hybrid instruments has an investment in U.S. property. The proposed regulations might therefore be another way to enforce the penalties associated with hybrid instruments (to the extent the TCJA’s other anti-hybrid provisions don’t otherwise do so), but they could also create planning opportunities. However, Treasury was undoubtedly bound to the section 245A construct, given its justification for the proposed regulations.
A Template?
The bold approach in the proposed section 956 regulations could indicate the direction Treasury will take in issuing international tax guidance in light of TCJA changes. There are other places it could act similarly to address rules that are now anachronistic following the enactment of a territorial regime and other changes introduced by GILTI.
Section 367(b)
Like section 956, section 367 was included primarily to ensure current U.S. taxation of foreign earnings in some cases when deferral would otherwise apply. Section 367(a) turns off nonrecognition provisions for some outbound transfers of property or stock to foreign persons, while section 367(b) gives the government broad authority to write regulations “necessary or appropriate to prevent the avoidance of Federal income taxes” for nonrecognition transactions involving foreign persons. Treasury and the IRS have exercised that authority broadly, requiring that U.S. shareholders include in income the “all E&P” amount for inbound reorganizations and liquidations and the section 1248 amount for some foreign-to-foreign reorganizations. Generally, in trying to ensure that taxpayers don’t avoid eventual tax on a CFC’s foreign earnings on stock dispositions, Treasury has required an inclusion under section 367(b).
Because the inclusions required by section 367(b) are taxable as deemed dividends, the section 245A dividends received deduction should apply to render those amounts effectively tax free to the exchanging U.S. shareholder. As a result, the whole purpose of the section 367(b) regulations is called into question: Who needs an antiabuse rule that creates a fictional deemed dividend, when that deemed dividend is already nontaxable? (Prior analysis: Tax Notes Int’l , Apr. 23, 2018, p. 517.)
In rewriting the section 367(b) regulations to avoid creating a deemed dividend from foreign-to-foreign reorganization transactions, Treasury would be on even firmer ground than it was with the proposed section 956 regulations because the section 367(b) regs aren’t statutorily mandated — they’re simply a product of Treasury’s antiabuse regulatory authority.
Section 304
Section 304 also creates a deemed dividend from some related-party transactions when no dividend has actually been paid, in both domestic and cross-border situations. Like section 1248, it was generally intended to prevent tax planning by ensuring ordinary income treatment in some cases when taxpayers could otherwise take advantage of lower tax rates available to capital transactions.
The dividend treatment resulting from the application of section 304 is mandated by statute, so Treasury has less leeway to turn off the construct than it does with section 367. But section 304(b)(5)(C), which addresses acquisitions by foreign corporations, provides Treasury with broad authority to “prescribe such regulations as are appropriate to carry out the purposes of this paragraph.” Further, section 304(b)(5)(A) provides that Treasury is to write regulations defining which E&P are considered attributable to the acquiring corporation’s stock in applying section 304(a). Those grants of authority could provide Treasury with enough latitude to restrict the application of the section 304 deemed dividend construct in some cases involving foreign corporations.
Previously Taxed Income
Section 959 provides rules for ensuring that CFC earnings previously taxed under the section 951 subpart F rules (including earnings taxed under section 951(a)(1)(B)) will escape double taxation when repatriated to the United States. It calls for creating an elaborate set of accounts that shareholders must maintain to track previously taxed earnings, depending on what provisions subjected those earnings to tax.
It’s hard to reconcile the complexity of those rules with the legislative purpose of section 245A — as articulated by Treasury in the proposed section 956 regulations — to establish a participation exemption system for the taxation of foreign income. Further, as noted in the preamble to the proposed section 956 regulations, section 245A(g) granted Treasury the authority to prescribe regulations or other guidance as necessary or appropriate to carry out the intentions of section 245A.
Government officials have indicated that they’re taking a fresh look at the section 959 regulations generally in light of the TCJA’s changes to international tax rules. But apparently those regulations will make the rules on previously taxed income (PTI) even more complicated, because while section 959 previously needed to reflect only two types of PTI — subpart F income and inclusions of section 956 property — there are now more layers of complexity. In addition to income taxed under section 951A, the PTI rules must account for foreign earnings that have been subject to taxation under the one-time repatriation tax (section 965), which itself was imposed at two different rates. And the government has had little success in promulgating coherent section 959 regulations. (Prior analysis: Tax Notes , May 25, 2015, p. 860.)
Why is section 959 still needed to track PTI when an actual dividend from foreign earnings — at least for corporate shareholders — should be exempt from tax anyway? There’s still one important benefit if a distribution is considered paid from PTI rather than from untaxed earnings fully deductible under section 245A: While taxpayers can’t claim an FTC for any dividend eligible for the section 245A dividends received deduction, distributions of PTI can allow a shareholder to claim an FTC for withholding taxes associated with the repatriated foreign earnings. PTI distributions can also result in the recognition of foreign exchange gain or loss, creating accounting complexities and significant financial statement implications.
It’s unclear how Treasury could eliminate the need for taxpayers to maintain complex tracking section 959 accounts while still allowing them to claim FTCs on distributions of PTI.
FTC Carryovers and Baskets
Section 904(f) contains rules to prevent taxpayers from benefiting from a foreign loss in one year by forcing a recharacterization of the source of foreign income in a subsequent year to a domestic source, thereby limiting taxpayers’ use of FTCs. Section 904(g) contains an offsetting rule — generally taxpayer favorable — if an overall domestic loss offsets foreign income. The intricate rules require taxpayers to separately track losses generated in the different section 904(d) FTC baskets (post-TCJA, the general limitation, passive, GILTI, and foreign branch baskets).
Because most CFC earnings are now immediately taxable to their U.S. shareholders either as subpart F income or GILTI, and because the taxes associated with those earnings will generally be creditable in the year the income is included or not at all, the need for an elaborate regime to protect against FTC planning over multiple tax years has mostly disappeared. But section 904(f), with all its complexity, remains part of the code. Eliminating the ability to carry over GILTI credits also renders moot in most cases the concerns behind enactment of section 904(f).
Section 904(f) doesn’t contain a broad grant of regulatory authority that could allow Treasury to eliminate the need for taxpayers to maintain overall foreign loss and separate limitation loss accounts, but section 904(d), which separates foreign-source income into baskets, does. Even if Treasury can’t eliminate section 904(f) via regulations, it might be able to use its section 904(d) authority to minimize taxpayer difficulty in having to keep track of separate limitation loss accounts, particularly for those baskets (GILTI) that don’t permit an FTC carryover or carryback.
The Hybrid Exception
Antiabuse rules often come back to haunt the government. That could be the case with the interaction of section 245A — meant to curtail benefits taxpayers might otherwise obtain through hybrid instruments — and the proposed section 956 regulations. While the proposed regs generally state that a section 956 inclusion will effectively be treated as eligible for the 100 percent dividends received deduction in section 245A, they don’t provide the same treatment for section 956 inclusions if there’s a hybrid instrument in the chain of ownership. As a result, when there’s a hybrid instrument in a chain of CFCs and a lower-tiered CFC has invested in section 956 property, the investment will still trigger a taxable inclusion under section 951(a)(1)(B), which will carry with it FTCs because of the application of section 960. Taxpayers wanting to trigger section 956 could insert a hybrid into the chain.
It’s unclear whether that kind of planning is worthwhile, but the existence of that possibility illustrates the challenge in writing antiabuse rules when the planning opportunities are unknown. Perhaps for that reason, Treasury has requested comments on the interaction with the anti-hybrid rule of section 245A(e).
Two Separate Regimes
The proposed section 956 regulations don’t apply to individual U.S. shareholders. There’s a basis for that difference: Section 245A doesn’t apply to individual shareholders either. But by drawing a sharp distinction, Treasury and the IRS have further widened the gap in the treatment of corporate and individual shareholders of foreign corporations, resulting in very different regimes. The underlying rationale for subjecting those shareholders to such widely disparate tax treatment is unclear. Because the difference will likely penalize small businesses — precisely the type of taxpayers the TCJA was supposed to help — increasing the gap between the two regimes is especially problematic.
Treasury has used its regulatory authority to issue regulations that attempt to bring consistency to the new territorial regime and the legislative policy of section 956, as adapted and interpreted over time. That renders inconsistent its arguments that it can’t revise its section 962 regulations to provide self-help to individual taxpayers subject to new — and for the most part, punitive — rules regarding their ownership of foreign corporations.
Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, director of its International Tax LLM program, and a contributor to Tax Notes International. Email: herzfeld@law.ufl.edu.