Final Section 956 regulations: Changes to proposed rules, impact of later guidance

Overview

On November 5, 2018, Treasury and the IRS published proposed regulations (the Proposed Regulations) under Section 956 that apply to ‘United States shareholders’ as defined under Section 951(b) (US shareholders) that are corporations.  Under the Proposed Regulations, a corporate US shareholder’s Section 956 inclusion with respect to a controlled foreign corporation (CFC) is reduced to the extent that a dividends received deduction (DRD) would be allowed under Section 245A if an amount equal to the potential Section 956 inclusion hypothetically had been distributed (‘hypothetical distribution’).  The Proposed Regulations were intended to create symmetry between actual distributions and Section 956 inclusions from a CFC, taking into account the impact of Section 245A.   

On May 23, 2019, Treasury and the IRS published final regulations under Section 956 (the Final Regulations) that largely adopt the Proposed Regulations (the Proposed Regulations and Final Regulations being collectively referred to herein as the Regulations in cases where they do not differ).  In addition to finalizing the Proposed Regulations, the Final Regulations make two important substantive changes.

The takeaway

The Regulations are intended to exempt amounts from taxation under Section 956 for corporate US shareholders to the extent those amounts would be eligible for the Section 245A DRD had an actual dividend distribution been made. 

The Proposed Regulations, as drafted, would not necessarily have accomplished that objective in cases where a CFC had prior-year Section 959(c)(1) PTEP.  Accordingly, in order to maintain the intended symmetry, the Final Regulations provide that for purposes of determining the amount of the Section 245A DRD that a US shareholder would be allowed by reason of a hypothetical distribution, the hypothetical distribution is treated as attributable first to Section 959(c)(2) PTEP and then to Section 959(c)(3) E&P.

Section 956 will continue to apply to US shareholders that are not corporations, such as individuals, regulated investment companies, and real estate investment trusts. Even if an individual elects to be treated as a corporation under Section 962 for purposes of calculating subpart F income, the individual still would not be eligible for the Section 245A DRD (and thus the current inclusion under Section 956 would not create asymmetry).

For corporate US shareholders, Section 956 still applies to the extent they would not be entitled to a Section 245A DRD with respect to the hypothetical distribution. In this regard, the Section 245A DRD has its own requirements, including minimum holding period requirements and rules against ‘hybrid dividends’, that should be validated and considered.  The subsequently issued temporary Section 245A regulations could further limit the potential applicability of these Section 956 regulations. Furthermore, the consequences of suffering a Section 956 inclusion in the post-tax reform world may be heightened due to the unavailability of the DRD or foreign tax credits to shelter a potential inclusion, as well as the risk of multiple Section 956 inclusions in the context of pledges and guarantees. 

For these reasons, corporate US shareholders should continue to exercise caution in entering into transactions that could give rise to ownership, or deemed ownership, of US property, including, inter alia, combining US and non-US cash pools, or providing collateral support from CFCs in connection with domestic borrowings.