On Oct. 31, 2018, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued proposed regulations (REG-114540-18) (the Proposed Regulations) updating the application of section 956 of the Internal Revenue Code (the Code) to account for changes to the U.S. international tax system due to the Tax Cuts and Jobs Act (the TCJA). Under section 956 of the Code, a corporate U.S. shareholder in a controlled foreign corporation (a CFC) generally had to take into income its pro rata share of the CFC’s amounts “invested” in the U.S. through the purchase of U.S. stock debt or other specified U.S. investments. Prior to the TCJA, U.S. shareholders subject to 956 were generally required to pay tax as if the amounts the CFC invested in such investments were actually distributed. The TCJA, however, brought about significant changes to the U.S. international tax system. One of the key changes was the creation of a participation exemption. Under the new participation exemption, section 245A of the Code allows certain U.S. corporations to offset certain dividend income from CFCs with a deduction. The deduction effectively makes dividends from CFCs tax exempt but it only applies to actual dividends, not amounts included under section 956. This difference in the tax treatment of actual dividends and the amounts included in income under section 956 undermines the Congressional intent to maintain parity between such amounts.
In order to re-establish such parity, the Proposed Regulations provide for a change in how the amount included under section 956 is calculated. Specifically, the Proposed Regulations would allow for a reduction in a U.S. shareholder’s section 956 amount to the extent that, if such amount were an actual dividend, a section 245A deduction would be allowed. Non-corporate U.S. shareholders will have to continue to apply the traditional rules of section 956, and will thus continue to be taxable on amounts included in their income under section 956.
Many corporate U.S. shareholders have been working to unwind structures that create income inclusions under section 956, so the Proposed Regulations provide welcome relief. U.S. shareholders that have included section 956 deemed dividends in the past should consult their advisors to discuss how these new Proposed Regulations, and more broadly, the TCJA, may provide for planning opportunities to reduce their overall effective tax rate.