IRS finalizes fixes to downward attribution rules

The IRS issued final regulations (T.D. 9908) and proposed regulations (REG-110059-20) on Sept. 21 addressing a number of unintended consequences caused by the repeal of Section 958(b)(4).

Section 958(b)(4) was repealed by the Tax Cuts and Jobs Act in an effort to narrowly target “de-control” transactions in which a foreign parent of a U.S. shareholder with a controlled foreign corporation (CFC) sheds the CFC status by acquiring the CFC’s stock. However, the full repeal of Section 958(b)(4) significantly expanded the scope of the downward attribution rules beyond what was intended.

The final regulations mostly adopt the proposed regulations published in October 2019, but broaden an exception related to the application of the CFC payee rule under Section 267(a)(3)(B). They did not finalize a provision related to passive foreign investment companies (PFICs), but the IRS has indicated it will be addressed in future PFIC specific guidance. The concurrently released proposed regulations are issued under Sections 367(a) and 954(c)(6) and address the modification of Section 958(b).

Taxpayers should review the final regulations, taking note of the changes to the CFC payee rule exception. They should also carefully evaluate the proposed regulations, which generally apply to outbound transfers of stock or securities of domestic corporations or payments between related CFCs made on or Sept. 21, 2020. The proposed rules may particularly impact foreign multinationals in a group with U.S. subsidiaries and U.S. shareholders, limiting their ability to move foreign earnings without subjecting U.S. investors to additional tax.


 

The final regulations

The final regulations largely adopt the 2019 proposed regulations, including the following provisions without substantive changes:

• Section 332(d)(3) provides that exchange treatment under Section 331 applies if the distributee of a distribution in complete liquidation of an applicable holding company is a CFC. The final regulations adopt the provision that reverts the definition of a CFC to the one in effect immediately before the repeal of Section 958(b)(4) for purposes of applying Section 332(d)(3).
• The Section 367(a) regulations provide a gain-recognition agreement triggering-event exception if, immediately after a disposition, the U.S. transferor meets certain requirements, including retaining a direct or indirect interest in the transferred stock or securities. The final regulations finalize the rule to apply Section 958(b) without regard to the repeal of Section 958(b)(4).
• Section 672(f)(3)(A) includes special rules generally providing that CFCs are treated as domestic corporations for purposes of Section 672(f)(1). The final regulations provide that the only CFCs taken into account for purposes of Section 672(f) are those that are CFCs without regard to downward attribution from foreign persons.
• Section 706 provides rules for determining the taxable year of a partnership and its partners. Under the Section 706 regulations, certain foreign partners’ interests are disregarded when making this determination, but CFCs are not treated as foreign partners. The final regulations adopt the proposed rule providing that CFCs that are CFCs by reason of downward attribution would not be treated as CFCs for purposes of the Section 706 regulations.
• Under Section 863, space and ocean income and international communications income is generally U.S.-sourced if derived by a U.S. person and foreign-sourced if derived by a foreign person. However, income derived by a CFC may be treated as U.S.-sourced income, in whole or in part, in certain circumstances. The final regulations finalize the proposed revision providing that CFC status is determined without regard to downward attribution from a foreign person for this purpose.
• Section 904(d)(3) provides an active rents and royalties exception for certain amounts received by a CFC. The final regulations limit the application of these and certain related rules to foreign corporations that are CFCs without regard to downward attribution from foreign persons.
• The regulations under Chapter 61 generally provide that the scope of payments or transactions subject to Form 1099 reporting depends, in part, on whether the payor is a U.S. payor, which generally includes U.S. persons and their foreign branches, as well as CFCs. The final regulations provide that a U.S. payor include only a CFC that is a CFC without regard to downward attribution from a foreign person.
• The final regulations adopt a rule modifying the Section 958(b) constructive ownership regulations to be consistent with the repeal of Section 958(b)(4).

The final regulations did not finalize the provision from the 2019 proposed regulations that modified the definition of a CFC for purposes of Section 1297(e) to disregard downward attribution from foreign persons. However, the IRS indicated that the provision will be finalized in separate regulations specific to PFICs.

The final rules also make one notable change to the 2019 proposed regulations that broadens the exception from the CFC payee rule under Section 267(a)(3)(B)(i), which generally provides that an item paid to a CFC is deductible by the payor only to the extent it is includible in the gross income of a Section 958(a) U.S. shareholder. The proposed regulations provided that an amount (other than interest) that is income of a related foreign person with respect to which the related foreign person is exempt from U.S. taxation on the amount owed pursuant to a treaty obligation of the United States is exempt from the application of Section 267(a)(3)(B)(i) if the related foreign person is a CFC that does not have any Section 958(a) U.S. shareholders.

The exception from the CFC payee rule is expanded in the final regulations to apply to all amounts payable to a related foreign person that is a CFC and that does not have any Section 958(a) U.S. shareholders. As a result, the foreign payee rule in Section 267(a)(3)(A) (i.e., the rule that applies to amounts owed to a foreign related party that is not a CFC) and the regulations under that section will apply to those payments exempt from the application of the CFC payee rule. However, the CFC payee rule continues to apply to a CFC that has a Section 958(a) shareholder even if the foreign corporation is a CFC due solely to the repeal of Section 958(b)(4).

The final regulations apply either to tax years ending on or after Oct. 1, 2019, or to certain transactions (e.g., accrued payments, liquidations, etc.) occurring on or after Oct. 1, 2019 depending on the operative regulation. For taxable years before the taxable years covered, a taxpayer may generally apply the final regulations to the last taxable year of a foreign corporation beginning before Jan. 1, 2018, and each subsequent taxable year of the foreign corporation. The final regulations also may be applied to taxable years of U.S. shareholders in which or with which such taxable years of the foreign corporation end, provided that the taxpayer and U.S. persons consistently apply the relevant rule with respect to all foreign corporations.


 

The 2020 proposed regulations

In addition to the final regulations, the IRS issued concurrent proposed regulations that modify the ownership attribution rules applicable to outbound transfers of stock or securities of a domestic corporation under Section 367(a), and modify the look-through rule under Section 954(c)(6) for payments made between related CFCs.

To obtain nonrecognition treatment on outbound transfers of stock or securities of a domestic corporation (the “U.S. target company”), Section 367(a) generally requires the U.S. target company to meet certain reporting requirements. Specifically, the following four requirements under Treas. Reg. Sec. 1.367(a)–3(c)(1) must be satisfied:

1. Fifty percent or less of both the total voting power and the total value of the stock of the transferee foreign corporation is received in the transaction, in the aggregate, by U.S. transferors.
2. Fifty percent or less of each of the total voting power and the total value of the stock of the transferee foreign corporation is owned, in the aggregate, immediately after the transfer by United States persons that are either officers or directors of the U.S. target company or that are 5% target shareholders.
3. Either the United States person is not a 5% transferee shareholder (as defined in § 1.367(a)– 3(c)(5)(ii)), or the United States person enters into a gain recognition agreement.
4. The active trade or business test is satisfied.

The 2020 proposed regulations provide that for purposes of applying requirements the first, second and fourth requirements above, a U.S. person’s constructive ownership interest should not include an interest that is treated as owned as a result of downward attribution from a foreign person. However, the constructive ownership rules as they apply to third requirement above will continue to take into account downward attribution.

The proposed regulations also narrow the scope of foreign corporations that are treated as CFCs for purposes of the look-through rule under Section 954(c)(6). Section 954(c)(6) provides generally that dividends, interest, rents, and royalties received or accrued by a CFC from another related CFC are not treated as foreign personal holding company income to the extent attributable to, or properly allocable to, income of the related CFC that is neither Subpart F income nor income treated as effectively connected income. The new rules limit the application of the Section 954(c)(6) exception to amounts received or accrued from foreign corporations that are CFCs without applying Section 318(a)(3)(A), (B) and (C) to treat a U.S. person as owning stock that is owned by a foreign person.

The proposed rule applies irrespective of whether the foreign payor corporation (that is a CFC solely as a result of downward attribution) has a section 958(a) U.S. shareholder. The IRS requested comments on whether, and to what extent, the Section 954(c)(6) exception should be available when a related foreign payor corporation has Section 958(a) U.S. shareholders and therefore is partially under U.S. taxing jurisdiction. This would seem to place a burden on foreign multinational groups that have ultimate U.S. investors that are Section 958(a) U.S. shareholders. First, it would prevent access to look-through even when the foreign payor is partially under U.S. taxing jurisdiction by way of an ultimate U.S. investor. Additionally, the Section 958(a) U.S. shareholder may have previously relied on look-through to prevent Subpart F income between two foreign corporations, both of which are CFCs solely as a result of downward attribution. This rule would seemingly turn off look-through in these situations and may subject the ultimate U.S. investor to increased amounts of Subpart F income.

The 2020 proposed regulations under Section 367(a) are proposed to apply to transfers made on or after Sept. 21, 2020. Subject to certain special rules, the 2020 proposed regulations under Section 954(c)(6) are proposed to apply to payments or accruals of dividends, interest, rents and royalties made by a foreign corporation during taxable years of the foreign corporation ending on or after Sept. 21, 2020, and to taxable years of United States shareholders in which or with which such taxable years of the foreign corporation end. Taxpayers also may apply the proposed regulations, once filed as final regulations in the Federal Register, to the last taxable year of a foreign corporation beginning before Jan. 1, 2018, and each subsequent taxable year of the foreign corporation, provided they are consistency applied. Taxpayers may rely on the 2020 proposed regulations with respect to any taxable year before the date they are finalized in the Federal Register, provided the taxpayer and related persons do so consistently with respect to all foreign corporations.

Next steps

The final regulations largely adopt the 2019 proposed regulations, but notably expand the exception related to the CFC payee rule under Section 267(a)(3)(B). Taxpayers should review the final regulations taking this change into consideration. They also should carefully evaluate the proposed regulations, which could impact outbound transfers of stock or securities of domestic corporations or payments between related CFCs made on or after Sept. 21, 2020. Foreign multinationals in a group with U.S. subsidiaries and ultimate U.S. shareholders, in particular, may be limited in their ability to move foreign earnings without subjecting U.S. investors to additional tax.