Working with speed rarely seen in the rulemaking process, the U.S. Treasury Department (Treasury) and the Internal Revenue Service (IRS) released final regulations (T.D. 9934) on Nov. 20, 2020, that coordinate the section 245A extraordinary disposition rule with the section 951A disqualified basis rule. The final regulations (Final Regulations) were released less than three months after they had been proposed (REG-124737-19). They are effective for taxable years of controlled foreign corporations (CFCs) beginning on or after the date they are published in the Federal Register and to tax years of section 245A shareholders in which or with which the tax years of the foreign corporations end. Taxpayers may also choose to apply the final regulations to tax years beginning before they are published and to tax years of section 245A shareholders in which or with which such tax years end, provided that the taxpayer and all related taxpayers adopt the rules in their entirety.
Section 245A, which was added to the Code by the 2017 Tax Cuts and Jobs Act (TCJA), provides a domestic corporation with a 100% dividends received deduction (DRD) for the foreign sourced portion of dividends received from specified 10% owned foreign corporations, provided certain requirements are met (e.g., domestic corporate shareholder must satisfy a holding period and the dividend may not be a ‘hybrid dividend’).
Section 951A, the global intangible low-taxed income (GILTI) provision, was also added by the TCJA and generally subjects U.S. shareholders of CFCs to current U.S. taxation on certain CFC earnings that exceed a 10% return on foreign tangible assets.
GILTI gap period
For certain fiscal-year CFCs, a gap existed between the effective date of the section 245A DRD provisions—Jan. 1, 2018—and the effective date of the GILTI provisions (the GILTI gap period). The GILTI provisions are first effective as of the first day of the first year beginning after Dec. 31, 2017. For fiscal year CFCs having a year-end of June 30, for example, the disqualified period was six months long. During this period, the CFC could sell assets to a related foreign party in a transaction not subject to GILTI. The sales proceeds could then be repatriated tax-free under the section 245A DRD. For the buyer, the sale would have created a stepped-up tax basis in the assets, thereby resulting in increased deductions for amortization and depreciation that could reduce the buyer’s future GILTI by both reducing tested income and increasing qualified business asset investment (QBAI).
Treasury and the IRS issued two independent sets of anti-abuse rules to shut down transactions like the one described above:
- The first set of anti-abuse rules (the section 245A extraordinary disposition rules) reduce the DRD allowed to a section 245A shareholder by an amount equal to 50% of the “extraordinary disposition amount.” In general, an extraordinary disposition is a disposition of certain property (specified property) by a CFC to a related party during the GILTI gap period and outside of the ordinary course of the CFC’s activities.
- The second set of anti-abuse rules (the section 951A disqualified basis rules) provide that a deduction or loss attributable to basis created from a transfer of property from a CFC to a related person during the GILTI gap period is allocated and apportioned to residual CFC gross income.
Regulations to coordinate the extraordinary disposition rule with the disqualified basis rule were deemed necessary to avoid double taxation. Double taxation could happen, first, in the form of a taxable dividend distributed by a CFC (due to the disallowed section 245A DRD); and second, as increased GILTI income from a CFC (because depreciation deductions and QBAI attributable to the disqualified basis would not reduce the GILTI tested income).
The Final Regulations adopt the rules from the proposed regulations with one revision.
The Final Regulations include two methodologies—one for simple cases and one for complex cases—providing for either the reduction to the extraordinary disposition account with respect to a CFC at the end of a given tax year or a reduction to the disqualified basis in specified property that corresponds to an extraordinary disposition account at the beginning of a given tax year. An item of specified property corresponds to an extraordinary disposition account if gain was recognized on the extraordinary disposition of the specified property and the gain was taken into account in determining the initial balance of the extraordinary disposition account.
One revision adopted by the Final Regulations is that prior extraordinary disposition amounts (e.g., extraordinary disposition E&P that give rise to an income inclusion to the section 245A shareholder by reason of sections 951(a)(1)(B) and 956(a)) also reduce disqualified basis under the disqualified basis reduction rule.
Taxpayers that engaged in an extraordinary disposition should consult with their tax advisors immediately to determine how the Final Regulations impact their extraordinary disposition account balances and disqualified basis.