Executive summary: Rules address transferring CFC within group to lower subpart F / GILTI
Treasury and the IRS released on Feb. 22, 2023, final regulations (TD 9973) treating consolidated group (the group) members as a single entity for purposes of determining income inclusions from controlled foreign corporations (CFCs) under the subpart F and global intangible low-taxed income (GILTI) regimes. The final regulations finalize proposed regulations that were released in Dec. 2022, without modification.
The final regulations are aimed at combating a narrow fact pattern, which involves distributions of previously taxed earnings and profits (PTEP) coupled with a CFC reorganization (i.e., changing the location of the ownership of stock of CFC) within the group. In such scenarios, the group's aggregate inclusions under sections 951(a)(1)(A) and 951A could be significantly reduced via the application of section 951(a)(2)(B).
Since the enactment of the one-time transition tax (section 965) and annual GILTI (section 951A) computation as part of the Tax Cuts and Jobs Act of 2017 (TCJA),1 a substantial amount of PTEP has arisen in the United States (U.S.) tax system. The final regulations preclude taxpayers from reducing their subpart F and GILTI inclusions by coupling a PTEP distribution made by a lower-tier CFC with a direct or indirect acquisition of that CFC by one member of a group from another group member.
The final regulations apply to taxable years for which the original consolidated return is due (without extensions) after the date of their publication in the Federal Register.
Overview of Reg. section 1.1502-80
Treasury and the IRS are concerned that some consolidated groups have taken the position that the group’s aggregate subpart F and GILTI inclusions are reduced by changing the ownership of a CFC within a group. Of specific concern is the taxpayer position that a group’s aggregate pro rata share of a lower-tier CFC’s subpart F and tested income (for GILTI) is reduced under section 951(a)(2)(B) by reason of a PTEP distribution under section 959(b) made by the lower-tier CFC. This reduction is affected by coupling such a distribution with a direct or indirect acquisition of the stock of the lower-tier CFC by one group member from another group member.
While not a new issue, both the one-time transition tax and annual GILTI inclusion have increased the amount of PTEP in the U.S. tax system.2 This has heightened concern that taxpayers are effecting the movement of the stock of CFCs between group members to significantly reduce their subpart F and GILTI inclusions.3 The IRS and Treasury view this practice as not clearly reflecting a consolidated group’s U.S. tax liability and as inconsistent with the purpose of section 951(a)(2)(B), which is to preclude PTEP from being taxed a second time upon distribution.4
A U.S. shareholder that owns stock (within the meaning of section 958(a)) in the CFC on the last day of the CFC’s taxable year must include in gross income its pro rata share of subpart F income. A U.S. shareholder’s share of subpart F income is reduced under section 951(a)(2)(B) by the amount of distributions received by any other person during the taxable year as a dividend with respect to the acquired stock. The amount of the section 951(a)(2)(B) reduction is limited to the amount of the dividend that would have been received had the CFC distributed its subpart F income (or GILTI) for the taxable year multiplied by the percentage of the taxable year (based on the number of days) the U.S. shareholder did not own the CFC stock. Identical rules apply for purposes of determining a U.S. shareholder’s GILTI inclusion (i.e., in determining its share of tested income or loss).5 Thus, a U.S. shareholder that acquires CFC stock in the middle of the taxable year may be able to reduce its subpart F and GILTI inclusions by a portion of distributions the CFC made to other persons throughout the taxable year.
The final regulations treat members of a group as a single U.S. shareholder for purposes of determining the portion of the year the shareholder did not own CFC stock under section 951(a)(2)(B).6 The rule would apply only to distributions of PTEP under section 959(b) (i.e., the rule does not apply to non-PTEP distributions). As such, it would preclude groups from reducing their aggregate subpart F and GILTI inclusions under section 951(a)(2)(B) (by PTEP distribution) through a change in the location of CFC stock ownership within the group.
Example 1 of the final regulations, intercompany transfer of stock of a CFC, illustrates this dynamic:
Example 1. P, the parent of a U.S. affiliated group that files a consolidated return, directly owns all of the stock of both M1 and M2 (P Group). M1 directly owns all of the stock of CFC1, which directly owns all of the stock of CFC2. In Year 1, CFC2 has $100 of subpart F income, and M1’s pro rata share of that subpart F income is $100. In Year 2, CFC2 has $80 of subpart F income and distributes $80 to CFC1, which constitutes a PTEP distribution under section 959(b). On Dec. 29, Year 2, M1 transferred all of its CFC1 stock to M2 in a section 351(a) exchange. As such, on Dec. 31, Year 2 (the last day of CFC2’s Year 2), M2 owns 100% of the stock of CFC1 (which still wholly owns all of CFC2's stock).
Under the final regulations, M1 and M2 would be treated as a single U.S. shareholder for purposes of determining any reduction to M2’s subpart F income under section 951(a)(2)(B). Consequently, the ratio of the number of days in Year 2 that M1 or M2 did not own the CFC2 stock to the total days in the year is 0/365. There is therefore a zero dollar reduction to M2’s subpart F amount under section 951(a)(2)(B). M2’s pro rata share of CFC2’s subpart F income included in gross income for Year 2 is $80 ($80 - $0).
Example 2 of the final regulations, the transfer of stock of a CFC between CFCs, illustrates the dynamics of another common scenario:
Example 2. The ownership structure and facts are identical to Example 1, except that M2 directly owns all 90 shares of CFC3's stock through Dec. 29, Year 2. Further, M1 does not transfer CFC1 stock to M2. Instead, CFC3 acquires all of the CFC2 stock from CFC1 in exchange for 10 newly issued shares of CFC3 stock (in a section 368(a)(1)(B) reorganization). On Dec. 31, Year 2, therefore, M1 and M2 indirectly own 10% and 90%, respectively, of the CFC2 stock.
Similar to the results in Example 1, M1 and M2 would be treated as a single U.S. shareholder for purposes of determining any reduction to M2’s subpart F income under section 951(a)(2)(B). Either M1 or M2 own the CFC2 stock for every day of Year 2. Consequently, M2 cannot reduce any part of its $80 subpart F inclusion by the $80 distribution of PTEP made by CFC1 to CFC2. Notably, the final rule would apply similarly in both examples for purposes of determining the amount of any reduction to M2’s GILTI inclusion.
The final regulations apply only to changes in CFC ownership within a consolidated group. They would not apply to other related party transfers—including transfers between members of an affiliated group that do not file a consolidated return. Further, the final regulations do not curtail the section 951(a)(2)(B) reduction of subpart F and GILTI in the context of dividends composed of non-PTEP. When a non-PTEP dividend gives rise to a section 951(a)(2)(B) reduction, other rules may result in the dividend being (directly or indirectly) included in the gross income of a U.S. shareholder.7
The final regulations treat a consolidated group as a single entity for purposes of calculating any reduction to subpart F and GILTI inclusions from distributions of PTEP under section 959(b). The enactment of the transition tax and GILTI as part of the TCJA increased the amount of PTEP in the U.S. tax system. The final rule addresses situations in which consolidated groups are reducing their total subpart F and GILTI inclusions under section 951(a)(2)(B) by changing the location of CFC ownership within the group.