IRS provides relief for taxpayers

Jun 26, 2019
Jun 26, 2019
0 min. read

Treasury and IRS issue final section 956 regulations

The U.S. Treasury Department (Treasury) and the Internal Revenue Service (IRS) have released final regulations (T.D. 9859) that effectively conform the tax treatment of deemed dividends under section 956 of the Internal Revenue Code (the Code) to actual dividends under section 245A for domestic C corporations (the Final Regulations). The Final Regulations were published in the Federal Register on May 23, 2019. These rules effectively make deemed dividends eligible for the exemption from federal income tax that applies to certain actual dividends paid to U.S. C corporations.

The Final Regulations generally adopt proposed regulations (the Proposed Regulations) that were released on Oct. 31, 2018 (see our alert IRS eliminates current tax on certain off-shore income), with two noteworthy changes:

  1. The addition of a taxpayer-favorable earnings and profits (E&P) ordering rule for controlled foreign corporations (CFCs) that have both previously taxed E&P (PTEP) from prior years and untaxed E&P in the current year
  2. The establishment of a special rule that applies to U.S. partnerships (including U.S. limited liability companies treated as partnerships for U.S. tax purposes) with domestic corporate partners

The Final Regulations apply to tax years of a CFC beginning on or after July 22, 2019. However, taxpayers may apply the Final Regulations to tax years beginning after Dec. 31, 2017, provided that the taxpayer and U.S. persons related to the taxpayer consistently apply the Final Regulations to all their CFCs.

A brief primer on section 956

Prior to the 2017 Tax Cuts and Jobs Act (TCJA), U.S. tax on the income earned by a domestic C corporation indirectly through a CFC was generally deferred until the income was distributed as a dividend from the CFC to the domestic C corporation. An important exception to this general rule is found in section 956. Enacted in 1962 (at the same time as the Subpart F rules), section 956 was intended to ensure that U.S. shareholders of a CFC that engaged in transactions that were considered “substantially the equivalent” of a dividend (such as loans of cash from a CFC to its U.S. shareholder) would be taxed as if a dividend had in fact been paid. In this respect, Congress created symmetry between the taxation of actual dividends and the taxation of so-called deemed dividends by subjecting section 956 deemed dividends to tax in the same manner as actual dividends.

Section 956, in conjunction with section 951(a)(1)(B) of the Code, requires a U.S. shareholder (whether or not a corporation) of a CFC to include in gross income an amount equal to the U.S. property held by the CFC for any tax year, limited by the amount E&P of the CFC, and reduced by amounts previously included in income under section 951 (i.e., amounts included by reason of section 956 in prior years, global intangible low-taxed income (GILTI), or generally under Subpart F (including amounts treated as Subpart F under section 965)). The amount of U.S. property held by a CFC is either the CFC’s adjusted basis in such property or, in the case of debt, the principal amount of such debt.

For this purpose, the term U.S. property means (1) tangible property located in the U.S., (2) stock of a domestic corporation, (3) debt of a U.S. person or (4) a right to use certain intellectual property in the U.S. In addition, a CFC’s guarantee of debt of a related U.S. person and a pledge of stock of a CFC representing more than two-thirds of the total combined voting power of all classes of voting stock of such CFC may be treated as an investment in U.S. property. For example, if a CFC guarantees a $5 million loan made to its U.S. shareholder, all of the CFC’s previously untaxed E&P up to $5 million may be taxed in the U.S. as a section 956 deemed dividend. Thus, for more than 50 years, section 956 has limited the ability of U.S. persons to use their overseas assets or revenues of CFCs as collateral or credit support for financing transactions.

Changes made by the Tax Cuts and Job Act

The TCJA contains the most sweeping changes to the Code in decades. For domestic C corporations, this includes, among other things, a 40% income tax rate cut (from 35% to a flat 21%) and a dividend exemption system under new section 245A that exempts from U.S. federal income tax dividends paid by foreign subsidiaries to their domestic corporate parents. Under the new system, if certain requirements are met, domestic corporate shareholders are entitled to a 100% dividends-received deduction (DRD) for the foreign source portion of the dividends received from the foreign corporation.

For a domestic C corporation to qualify for the DRD on its foreign profits, it needs to satisfy the following three requirements:

  1. The domestic corporation must own 10% or more of the vote or value of the foreign corporation’s stock.
  2. The domestic corporation must satisfy a holding period requirement of 366 days.
  3. The domestic corporation cannot deduct a dividend from U.S. taxable income if that dividend received a tax benefit in a foreign country. Specifically, this is to prevent “hybrid dividends” that receive a deduction in the foreign country when paid to the U.S. and when received in the U.S., resulting in effectively no tax on that stream of income.

Notably, the DRD under section 245A does not apply to section 956 inclusions because a section 956 inclusion is not technically a dividend. Early versions of the TCJA (section 4002 of the House bill and section 14218 of the Senate amendment) would have excluded domestic C corporations from the application of section 956, but this provision was ultimately dropped from the final bill (presumably due to revenue scoring) and section 956 was retained without modification. This created a mismatch for domestic corporate shareholders of CFCs: actual cash distributions from CFCs would be exempt from tax, but deemed dividends under section 956 would be taxed – a result at odds with the purpose of section 956.

The Final Regulations

The Final Regulations are intended to correct this mismatch between a CFC’s actual dividends and section 956 deemed dividends. The Final Regulations, like the Proposed Regulations, accomplish this by providing that the amount otherwise included under section 956 (the “tentative section 956 amount”) is reduced to the extent that the domestic corporate shareholder would be allowed a deduction under section 245A if the shareholder had received a distribution from the CFC in an amount equal to the section 956 inclusion (the “hypothetical distribution”). For example, a domestic corporate shareholder that receives a $10 million loan from a CFC would not recognize income under section 956 if that shareholder would have been entitled to a $10 million DRD if the CFC had instead paid an actual dividend.

With respect to a lower-tier CFC, the Final Regulations treat the domestic corporate shareholder as directly owning the stock of the lower-tier CFC, so that a section 956 inclusion from a lower-tier CFC may also qualify for the exclusion.

U.S. individuals (including those that make an election to be taxed as a corporation under section 962), regulated investment companies, and real estate investment trusts, continue to be subject to tax on any section 956 deemed dividend just as under prior law – which is consistent with the section 245A DRD being available only to domestic corporate shareholders. In addition, section 956 will continue to apply in situations where the domestic corporate shareholder does not meet the holding period requirements of Section 245A, a CFC has U.S.-source earnings, or the deemed distribution of foreign earnings would result in a hybrid dividend (for example, where dividends paid to the domestic corporate shareholder are treated as deductible interest payments in the CFC’s home country). As a practical matter, however, due to the section 965 transition tax, the new GILTI regime under section 951A, and the existing Subpart F rules, all or a large portion of a CFC’s earnings may treated as PTEP so that post-TCJA a section 956 inclusion may result in little, if any, incremental tax for a U.S. shareholder.

Ordering rule for allocation of hypothetical distribution

The Final Regulations add a new ordering rule intended to avert a technical issue that could occur with respect to CFCs that have PTEP attributable to prior section 956 inclusions (the “section 956 PTEP”) and untaxed E&P in the current year that would be eligible for the section 245A DRD if distributed.

In general, section 959(c) of the Code divides PTEP into three categories and provides that PTEP will be treated as distributed: first, out of the section 956 PTEP; second, out of PTEP attributable to Subpart F and GILTI inclusions (Subpart F and GILTI PTEP); and third, to non-previously taxed E&P. Without a rule providing otherwise, a hypothetical distribution would be treated as attributable first out of the section 956 PTEP, which is not eligible for the section 245A DRD. Accordingly, the domestic corporate shareholder would continue to have a section 956 inclusion up to the amount of the section 956 PTEP.

To address this issue, the Final Regulations include an ordering rule under which the hypothetical distribution is treated as attributable first to Subpart F and GILTI PTEP, and then to non-previously taxed E&P, with no amount of the hypothetical distribution being treated as attributable to the section 956 PTEP.

Domestic partnerships and their partners

The Final Regulations also add a new rule that addresses domestic C corporations that own stock of a CFC through a domestic partnership. Under this rule, the tentative section 956 amount with respect to a domestic partnership is reduced to the extent that one or more domestic corporate partners would have been entitled to a section 245A DRD on such a distribution, with any remaining amount allocated to partners in the same proportion as net income would have been allocated to the partners if the CFC made an actual distribution to the domestic partnership.


For many domestic corporate shareholders, the Final Regulations restore symmetry between the taxation of a CFC’s actual dividends and section 956 deemed dividends and may eliminate the need to impose restrictions on the credit support that CFCs can provide to corporate borrowers. The Final Regulations may also create new opportunities to repatriate cash, particularly for domestic C corporations who have avoided paying dividends that would have been subject to foreign withholding taxes. Non-corporate U.S. shareholders, and those domestic corporate shareholders that would fail to satisfy the requirements of section 245A, however, must continue to closely monitor exposure to section 956 inclusions.

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