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Proposed Regulations Under Section 956 Provide Benefits for Corporate Taxpayers

On October 31, 2018, the Internal Revenue Service (IRS) and US Department of the Treasury (Treasury) released proposed regulations (REG-114540-18) (the Proposed Regulations) that would prevent, in many cases, income inclusions for corporate US shareholders of controlled foreign corporations (CFCs) under section 956. As a result, among other considerations, the Proposed Regulations could significantly expand the ability of corporate US affiliates to benefit from credit support of CFCs.

Section 951(a)(1)(B) generally requires a US shareholder of a CFC to include in gross income its pro rata share of amounts determined under section 956 (section 956 amounts) resulting from investments by the CFC in US property. Such investments include tangible property located in the US and stock and obligations of related US persons. Section 956 is intended to ensure that a US shareholder is taxed in the same manner as if the CFC’s earnings that are invested in US property had actually been repatriated to the US shareholder.

Against this background, the 2017 tax act introduced a limited participation exemption system to facilitate the repatriation of earnings. Under section 245A, corporate US shareholders of CFCs may generally claim a 100 percent deduction with respect to foreign source dividends paid by their CFCs if a one year holding period requirement is satisfied. The deduction is not available with respect to “hybrid dividends” received by the US shareholder (generally, dividends for which the CFC received a deduction (or other tax benefit) in a foreign country). The preamble to the Proposed Regulations explains that as a result of the new participation exemption, a broad application of section 956 to corporate US shareholders would no longer achieve symmetry between the treatment of actual repatriations (i.e., dividends) and effective repatriations through the CFC’s investment in US property.

To address this inconsistency, the Proposed Regulations generally provide that a corporate US shareholder’s section 956 amount with respect to a CFC is reduced to the extent that the US shareholder would be allowed a deduction under section 245A if the US shareholder had received a distribution of such amount from the CFC (hypothetical distribution). Therefore, under the Proposed Regulations, a US shareholder that meets the one year holding period and hybrid dividend requirements under section 245A with respect to the CFC reduces its section 956 amount.

In the case of a lower-tier CFC, the Proposed Regulations generally apply section 245A with respect to the hypothetical distribution as if the US shareholder directly owned shares in the lower-tier CFC. In this case, the hybrid dividend rule applies as if the hypothetical distribution were made to the US shareholder by the lower-tier CFC through all upper-tier CFCs; if the hypothetical distribution would be subject to the hybrid dividend rule at any tier, then the section 956 amount is not reduced under the Proposed Regulations.

To illustrate, assume USP owns CFC1, which owns CFC2, with each entity having only common shares outstanding. CFC2 has $100 of untaxed earnings (e.g., because of “tested income” that was offset by a “tested loss” from another CFC). If CFC2 loans $100 to USP (an investment in US property for purposes of section 956), then USP’s section 956 amount will be reduced by the portion of the $100 that would have been eligible for section 245A if CFC2 had directly distributed such amount to USP.

The Proposed Regulations are very favorable to corporate taxpayers by significantly expanding the ability of US corporate borrowers to benefit from the credit support of CFCs. Historically, US groups have not benefitted from collateral support or guarantees from their CFCs because a CFC is treated as making a loan to a US affiliate if it guarantees a third-party loan of the affiliate, or pledges its assets to support the loan, or if the US borrower pledges more than two-thirds of the stock of the CFC to the lender in support of the loan. After the effective date of the regulations, lenders and US borrowers may consider implementing pledges and guarantees from CFCs without the risk of section 956 inclusions for the US borrower. US borrowers should diligence their CFCs to ensure that the requirements of section 245A are met prior to implementing any particular CFC guarantee or pledge.

In the mergers and acquisitions context, the Proposed Regulations should reduce the adverse tax consequences of maintaining a “sandwich” structure following the acquisition of a foreign target that owns stock in a US subsidiary. Furthermore, the Proposed Regulations would accommodate acquisition structures that step up the basis of other US assets owned by a foreign target, such as intangible property used in the US which could otherwise result in a taxable investment in US property.

Section 956 will continue to apply without modification to individuals, regulated investment companies and real estate investment trusts. In addition, the IRS and Treasury have requested comments as to how the Proposed Regulations should apply to US shareholders that are domestic partnerships, which may have corporate US partners.

The Proposed Regulations would be effective for taxable years of a CFC beginning on or after the date on which the Proposed Regulations are finalized. However, taxpayers may rely on the Proposed Regulations immediately for taxable years beginning after December 31, 2017, provided that the Proposed Regulations are applied consistently with respect to all CFCs.

© 2020 McDermott Will & Emery


About this Author

Lowell D. Yoder, International Tax Planning, Attorney, McDermott Will, Law Firm

Lowell D. Yoder is a partner in the law firm of McDermott Will & Emery LLP and is based in the Chicago office.  He is head of the U.S. & International Tax Practice Group. Lowell’s practice focuses on international tax planning for multinational companies.   He handles cross-border acquisitions, dispositions, mergers, reorganizations, joint ventures and financings.  He advises concerning multi-jurisdictional business structures and the use of special purpose foreign entities.  He also works with an extensive network of foreign lawyers on developing structures that minimize...

Timothy S Shuman, Corporate Tax Attorney, McDermott Law Firm

Timothy S. Shuman is a partner in the law firm of McDermott Will & Emery LLP and is based in the Firm's Washington, D.C., office.  Tim focuses his practice on corporate and international tax matters for U.S. and foreign multinationals, with particular emphasis on acquisitions, dispositions, restructurings and liquidations.  He has extensive experience in structuring and providing advice on tax-free reorganizations and spin-offs involving both privately held and publicly traded companies and regularly represents clients in obtaining private letter rulings and other guidance from the IRS.  His work has included a number of corporations with special tax status, such as regulated investment companies.

Tim also has experience with international tax issues including supply chain planning and principal structures, foreign tax credit planning, tax-efficient repatriation strategies, tax basis planning and cross-border mergers and acquisitions.

Tim also has represented a number of clients before the IRS in connection with audits and the IRS Appeals process, including with respect to worthless stock losses and foreign tax credit issues. 

202 756 8280
Bradford LaBonte, McDermott Law Firm, Tax Attorney

Bradford E. LaBonte focuses his practice on US and international tax matters. He advises multinational corporations and investment funds on matters related to cross-border mergers and acquisitions, cash repatriation, controlled foreign corporation (CFC) and passive foreign investment company (PFIC) regimes, financial instrument classification, US trade or business determinations, US income tax treaty qualification and planning, and US withholding tax issues.