United States

Final regulations close section 245A loopholes

IRS releases final and proposed section 245A regulations

TAX ALERT  | 

On Aug. 21, 2020, the Internal Revenue Service (IRS) released final regulations (T.D. 9909) under sections 245A and 954(c)(6) (the Final Regulations). The Final Regulations purport to close certain gap-year and other “loopholes” that, according to the IRS, use the section 245A dividends received deduction (DRD) and the section 954(c)(6) look-through exception contrary to legislative intent. The Final Regulations also include rules under section 6038 regarding information reporting to facilitate administration of the Final Regulations. These regulations finalize (with limited modifications) proposed regulations, and remove temporary regulations, issued in June 2019 (collectively, the 2019 Regulations). 

The Final Regulations form part of a broader regulatory package that also includes new proposed regulations coordinating the application of section 245A and the global intangible low-taxed income (GILTI) provision on disqualified basis (REG-124737-19) (the 2020 Proposed Regulations). The 2020 Proposed Regulations similarly include rules under section 6038 regarding information reporting to facilitate administration of the 2020 Proposed Regulations.

This alert discusses the basic mechanics of the extraordinary disposition, extraordinary reduction, and disqualified basis rules, summarizes some of the important modifications included in the Final Regulations, and provides a high-level overview of the 2020 Proposed Regulations.

Effective dates

Final Regulations: The Final Regulations apply for tax years ending on or after June 14, 2019 (the date the proposed regulations were published in the Federal Register). Transactions completed after Dec. 31, 2017, and before the Final Regulations apply, continue to be subject to the temporary regulations. However, a taxpayer may choose to apply the Final Regulations to transactions completed during this period, provided that the taxpayer and all related parties consistently apply the Final Regulations in their entirety.

2020 Proposed Regulations: The 2020 Proposed Regulations are proposed to apply to tax years of foreign corporations beginning on or after the date of publication of final regulations in the Federal Register, and to tax years of a U.S. person in which or with which such tax years of foreign corporations end. The 2020 Proposed Regulations, however, allow for retroactive application, provided the taxpayer and all related parties apply the rules consistently.

Background

The 2017 Tax Cuts and Jobs Act (TCJA) significantly altered the tax rules governing U.S.-parented multinational groups by shifting from a worldwide system of taxation (where foreign source income earned by a foreign subsidiary was not subject to U.S. tax until repatriated or deemed repatriated) to a quasi-territorial one. A key element of the new system is the establishment of a participation exemption under section 245A which allows domestic corporations a 100% DRD for the foreign source portion of a dividend received from a specified 10% owned foreign corporation (SFC) provided that certain requirements are met (e.g., corporate shareholder must satisfy a holding period and the dividend may not be a “hybrid dividend” as defined in section 245A(e)). To transition to this new system, the TCJA imposed a reduced tax under section 965 on certain earnings and profits (E&P) held offshore (i.e., income that would have been subject to full U.S. taxation pre-TCJA upon repatriation to shareholders).

The TCJA’s legislative history expressed concern that the section 245A DRD could heighten the incentive to shift profits to low-tax foreign jurisdictions or tax havens absent base erosion protections. For example, a domestic corporation might shift income to a low-taxed foreign affiliate, and that income could potentially be distributed back to the domestic corporate shareholder without the imposition of any U.S. tax. Therefore, to prevent this type of base erosion, the TCJA retained the subpart F regime and enacted the GILTI provisions. 

The preamble to the Final Regulations (like the preamble to the 2019 Regulations) emphasizes that section 245A is part of a closely integrated framework of international tax rules designed to exempt only those foreign earnings that have first been subjected to either the section 965 transition tax, the subpart F regime, or the GILTI provisions, and that the rules espoused in the Final Regulations are targeted at specific transactions that do not conform to that policy objective.

The Final Regulations

The Final Regulations contains a general rule that a section 245A DRD is limited to the portion of a dividend that exceeds the “ineligible amount.” In general, the ineligible amount is the sum of (i) 50% of the extraordinary disposition amount, and (ii) 100% of the extraordinary reduction amount.

Extraordinary disposition amount: For certain fiscal-year controlled foreign corporations (CFCs), a gap existed between the last E&P measurement date for purposes of the section 965 transition tax—Dec. 31, 2017—and the effective date of the GILTI provisions (the disqualified 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 November 30, for example, the disqualified period was 11 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 (and subject to the disqualified basis rules discussed below), 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). The IRS believes that it would be inconsistent with the closely integrated framework of international tax rules for earnings attributable to such “extraordinary dispositions” to be eligible for the section 245A DRD.

To prevent this result, the Final Regulations reduce the DRD allowed to a section 245A shareholder by an amount equal to 50% of the “extraordinary disposition amount” (which is meant to approximate the 50% deduction domestic corporations generally are eligible for if such earnings were includable as GILTI). For a disposition to be an extraordinary disposition, the disposition must be: (i) a disposition of specified property (i.e. property that produces gross income that would be subject to GILTI), by an SFC, (ii) made on a date the SFC was also a CFC, (iii) during the SFC’s disqualified period, (iv) to a related party, (v) that occurs outside of the ordinary course of the SFC’s business. 

Whether a disposition of specified property occurs outside the ordinary course of an SFC’s business is determined by considering the facts and circumstances, including the quantity and frequency of the SFC’s past activities, and whether the SFC regularly disposes of similar property to related parties. The 2019 Regulations provided a per se rule that a disposition is treated as outside of the ordinary course of an SFC’s business if the disposition was undertaken with a principal purpose of generating E&P during the disqualified period or if the disposition was of intangible property, within the meaning of section 367(d)(4). In response to comments, the Final Regulations create an exception to the per se rule for certain intangible property if there was a reasonable expectation that such property would be re-sold to an unrelated customer within one year of the transfer. Transfers of trademarks and goodwill, however, are not eligible for this exception because, in general, these types of intangible property are not routinely sold to unrelated customers.

U.S. shareholders are required to maintain an extraordinary disposition account to track the extraordinary disposition amount and distributions of the same. The Final Regulations clarify that an extraordinary disposition account is maintained in the same currency as the extraordinary disposition E&P. The Final Regulations also provide that an extraordinary disposition account balance is eliminated if (i) the stock of the SFC is transferred to an unrelated party, and (ii) following the transfer, no person is a section 245A shareholder with respect to the SFC.

Under a de minimis exception, no amount is considered as arising from an extraordinary disposition if the sum of the net gain recognized by the SFC on all specified property dispositions is the lesser of (i) $50 million, or (ii) 5% of the gross value of all of the SFC's property held immediately before the disqualified period.

The Final Regulations do not address the impact of a nimble dividend (i.e., dividends paid from current E&P by a corporation that has an accumulated deficit) on extraordinary disposition accounts. The preamble notes that the IRS is studying the extent to which nimble dividends should qualify for the section 245A DRD generally and may address this issue in future guidance under section 245A.

Extraordinary reduction amount: In addition to extraordinary disposition transactions, which were only possible during the GILTI gap period, the regulations are also concerned with planning based on the interaction of section 951(a)(2)(B), which reduces a U.S. shareholder’s pro rata share of CFC subpart F income or GILTI tested income for dividends a different taxpayer receives in respect of the same CFC stock, and the section 245A DRD. To shut down this planning, the Final Regulations treat dividends (or deemed dividends) that occur in the same year as an “extraordinary reduction” ineligible for the DRD to the extent of the U.S. shareholder’s pre-reduction, pro rata share of the CFC’s subpart F income or GILTI tested income. An extraordinary reduction occurs when a controlling section 245A shareholder (generally, a U.S. corporate shareholder that owns more than 50% of the stock of the CFC) transfers more than 10% of its stock in a CFC or there is a greater than 10% dilution in the controlling section 245A shareholder's overall ownership of the CFC.

Example 3 of the Final Regulations illustrates the perceived abuse the extraordinary reduction provisions were designed to combat. At the beginning of CFC1’s tax year ending on Dec. 31, 2021, US1 owns all of the stock of CFC1, and CFC1 has no E&P described in section 959(c)(1) or (2). As of the end of 2022, CFC1 has $160 of GILTI and no other income, so that CFC1 has $160 of E&P for 2022. On Oct. 19, 2022, US1 sells all of its CFC1 stock to US2 for $100 in a transaction in which US1 recognizes $90 of gain.

Under section 1248(a), the entire $90 of gain is included in US1's gross income as a deemed dividend, and, under section 1248(j), the $90 would be treated as a dividend for purposes of applying the section 245A DRD. At the end of year 2022, however, US2 would take into account only $70 of tested income, calculated as $160 (100% of the $160 of GILTI) less $90, the amount of dividend deemed received by US1 described in section 951(a)(2)(B).

In this example, and absent limitation, the section 245A DRD eliminates taxation of the section 1248 deemed dividend, while section 951(a)(2)(B) reduces the post-sale GILTI tested income by $90 (the amount of the deemed dividend). To preclude this result, the section 1248 deemed dividend in the example would qualify as an extraordinary reduction amount under the Final Regulations. Therefore, with respect to the $90 deemed dividend received by US1, no portion is eligible for the section 245A DRD. Further, no foreign tax credits are allowed with respect to the deemed distribution. As a result, the entire $90 deemed dividend is subject to U.S. tax at the 21% rate.

The regulations include several exceptions that may potentially help taxpayers avoid the harsh results in the above example. First, under a de minimis rule, no amount is considered an extraordinary reduction amount regarding a controlling section 245A shareholder if the sum of the CFC’s subpart F income and GILTI tested income for the year does not exceed the lesser of (i) $50 million, or (ii) 5% of the CFC’s total income for the tax year. Next, an extraordinary reduction does not include a transaction pursuant to which the CFC’s taxable year ends (e.g., transactions where the buyer makes a 338(g) election) provided the controlling section 245A shareholder recognizes it’s pro rata share of subpart F and GILTI. Finally, the section 245A DRD may be preserved if the controlling section 245A shareholder affirmatively elects to close the tax year of the CFC at the time of the sale and recognize its pro rata share of subpart F income or GILTI for the short year. Returning to the above example, if US1 makes the election, it would take into account all of CFC1's GILTI tested income for the Jan. 1, 2021 to Oct. 19, 2021 period and US2 would take into account all of CFC1's GILTI tested income for the Oct. 20, 2021 to Dec. 31, 2021 period. As such, no amount would be considered an extraordinary reduction amount with respect to US1. Because GILTI may be reduced by the section 250 deduction and by certain foreign tax credits, making the election could potentially reduce or even eliminate the 21% tax that would be incurred without the election.

The Final Regulations clarify that each controlling section 245A shareholder participating in the extraordinary reduction with an extraordinary reduction amount greater than zero, and each U.S. tax resident that is a U.S. shareholder of the CFC at the end of the day of the extraordinary reduction, must enter into a binding agreement to close the taxable year of the CFC. The Final Regulations also allow a U.S. tax resident that owns its interest in the CFC through a partnership to delegate the authority to enter into the binding agreement on its behalf provided that the delegation is pursuant to a written partnership agreement.

The Final Regulations do not contain special rules for extraordinary reductions occurring as a result of section 368 reorganizations or transfers qualifying under section 351 or section 721. The preamble notes that the IRS is studying these transactions and their potential to avoid the purposes of the extraordinary reduction rules and request comments.

Section 954(c)(6) look-through exception: Section 954(c)(6) provides that dividends received by an upper-tier CFC from a related lower-tier CFC are not treated as foreign personal holding company income (and therefore do not give rise to subpart F income for the upper-tier CFC) to the extent the dividend is attributable to income of the lower-tier CFC that is neither subpart F income nor effectively connected income. The IRS voiced concern that the section 954(c)(6) look-through exception may cause dividends from one CFC to another to result in tax consequences similar to those presented in a first-tier extraordinary reduction or extraordinary disposition transaction. To protect against avoidance of those two rules, the Final Regulations (i) deny application of the CFC look-through exception in cases where a dividend from a lower-tier CFC to an upper-tier CFC would be an extraordinary disposition amount if distributed directly to the section 245A shareholders of the lower-tier CFC (the denial is limited by 50% to provide similar treatment for a dividend received directly by a U.S. shareholder from a CFC), and (ii) limit the amount of distributions from a CFC out of E&P attributable to subpart F or GILTI that can qualify for the CFC look-through exception in a tax year in which an extraordinary reduction occurs with respect to the CFC’s stock.

The 2020 Proposed Regulations

The GILTI regulations treat certain CFC asset basis as “disqualified basis” (DQB) that cannot be taken into account in determining QBAI or in determining depreciation or amortization deductions that reduce GILTI tested income. Instead, the GILTI regulations provide that such deductions are allocable to “residual CFC gross income,” which is income that is not subpart F income, GILTI tested income, or income effectively connected with a U.S. trade or business. DQB means the adjusted basis of property immediately after a disqualified transfer less the basis immediately before such transfer. A disqualified transfer is a transfer of property during a CFC transferor’s disqualified period (the gap period between the section 965 transition tax and GILTI effective date, as noted above). For example, if CFC1 sold depreciable property to related CFC2 during the disqualified period, any depreciation deductions attributable to the basis step-up cannot be allocated to GILTI tested income. Rather, CFC2 must allocate the depreciation deductions to residual income.

Commenters raised concerns that transfers of property by a CFC during its disqualified period may have resulted in both DQB and an extraordinary disposition account, which could give rise to excess taxation of a section 245A shareholder or a section 245A shareholder and related party. In response to these comments, the 2020 Proposed Regulations provide detailed mechanisms to coordinate the two sets of rules. The coordination mechanism involves two operative rules: one that reduces DQB in certain cases (the DQB reduction rule), and another that reduces an extraordinary disposition account in certain cases (the EDA reduction rule). The 2020 Proposed Regulations provide two versions of both the DQB reduction rule and the EDA reduction rule. The first version would apply to simple CFC structures, and the second version would apply to complex CFC structures.

Takeaway

Taxpayers should consult with their tax advisors to determine whether any historical transactions previously labeled as extraordinary dispositions should be revisited in light of the Final Regulations and 2020 Proposed Regulations, particularly with regard to transfers of intangible property. It will also be important for taxpayers and their advisors to model the impact of the extraordinary reductions rules on future M&A deals involving CFCs and to analyze whether making the election to close the tax year of the CFC at the time of transaction could potentially reduce or even eliminate taxation.

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