IRS Issues Proposed Regulations Reducing Income Inclusions under Section 956 for Certain U.S. Corporations

November 2, 2018

On October 31, 2018, the U.S. Treasury Department and the Internal Revenue Service issued proposed regulations (the "Proposed Regulations") that would generally reduce the amount that a corporate U.S. shareholder is required to include in income under Section 956,1 to the extent the shareholder would have been entitled to a deduction under Section 245A if the amount determined under Section 956 had instead actually been distributed to the shareholder.

The purpose of the Proposed Regulations is to realign the taxation of actual dividends paid by foreign corporations to U.S. shareholders with the taxation of U.S. shareholders who own stock of foreign corporations that make investments in United States property (including actual and deemed investments in the obligations of a U.S. person), which Congress has described as "substantially the equivalent of a dividend" to them. Historically, actual dividends paid by foreign corporations out of foreign earnings were taxed to U.S. shareholders as ordinary income, and under certain circumstances, Section 956 provided the same treatment for certain U.S. shareholders of controlled foreign corporations, or CFCs, that made investments in United States property. Section 956 applies to a domestic shareholder who owns 10 percent or more of the stock, by vote or value, of a foreign corporation, and references to U.S. shareholders below are generally limited to domestic shareholders meeting the 10 percent threshold. A CFC is a foreign corporation more than 50 percent of the stock of which, by vote or value, is owned actually or constructively by U.S. shareholders.

However, Section 245A changed the taxation of actual dividends. Section 245A was added by the legislation commonly referred to as the Tax Cuts and Jobs Act (the "Act"), which was enacted on December 22, 2017. Section 245A generally allows corporate U.S. shareholders a deduction of 100 percent of any dividends paid by foreign corporations (including CFCs) out of foreign earnings, if certain holding period requirements are met.

In order to realign Section 956 with the taxation of actual dividends, the Proposed Regulations adopt a "hypothetical distribution" approach. Under the Proposed Regulations, a U.S. shareholder calculates its Section 956 amount as it normally would, taking into account its pro rata share of the CFC's investment in United States property and the CFC's earnings and profits ("E&P"). The U.S. shareholder then determines the amount of any deduction under Section 245A that would be allowed if the CFC were to distribute this "tentative" Section 956 amount to the U.S. shareholder on the last day of the CFC's taxable year during which it is a CFC. For purposes of determining the U.S. shareholder's inclusion under Section 956, the U.S. shareholder's tentative Section 956 amount is then reduced by the deduction that would have been allowed.

For this purpose, the U.S. shareholder is generally treated as directly owning any stock of lower tier CFCs that it is treated as owning under Section 958(a). This is important because otherwise, if the hypothetical distribution was treated as made through the chain of ownership, the amount that would be eligible for the Section 245A deduction might be reduced by any intermediate CFC's current deficits in E&P or by E&P that was previously taxed, including as subpart F income, under the deemed repatriation provisions of the Act, or under the new GILTI regime (such previously taxed E&P, "PTI").2

This hypothetical distribution approach is especially helpful to corporate U.S. shareholders that own CFCs with untaxed E&P that cannot practically be distributed as an actual dividend—e.g., CFCs that have untaxed earnings and profits that exceed the CFC's distributable assets, or CFCs that have both untaxed E&P and PTI, where the PTI would be treated as distributed first under the ordering rules of Section 959 of the Code. Without the Proposed Regulations, such U.S. shareholders are not able to exercise "self-help" by paying an actual dividend eligible for deduction under Section 245A in order to eliminate E&P that is potentially taxable on account of Section 956.

The Proposed Regulations are expected to reduce the risk of income inclusions under Section 956 for corporate U.S. shareholders in many circumstances, including, for example, when U.S. corporations pledge subsidiary CFC stock or provide subsidiary CFC guarantees in respect of borrowings. However, the Proposed Regulations will not affect the application of Section 956 with respect to individual or other non-corporate U.S. shareholders of CFCs, because the deduction under Section 245A is only available to domestic corporations.

The Proposed Regulations will apply to taxable years of a CFC beginning on or after the date they are finalized. However, taxpayers may rely on the Proposed Regulations for taxable years of a CFC beginning after December 31, 2017 (and taxable years of U.S. shareholders in which such taxable years of a CFC end) if the Proposed Regulations are applied consistently with respect to all CFCs in which the taxpayer is a U.S. shareholder.

For further information, please contact Greg Broome (, 415-947-2139); Eileen Marshall (, 202-973-8884); Myra Sutanto Shen (, 650-565-3815); Jonathan Zhu (, 650-849-3388); or any member of the tax practice at Wilson Sonsini Goodrich & Rosati.

Derek Wallace and Timothy Shapiro contributed to the preparation of this WSGR alert.

1 All Section references herein are to the Internal Revenue Code of 1986, as amended.
2 For purposes of applying the rules that disallow the Section 245A deduction with respect to certain "hybrid dividends," however, the hypothetical distribution is treated as made through the chain of ownership. The apparent purpose of this rule is to deny the benefit of the Proposed Regulations in the case of lower-tier CFCs owned through intermediate CFCs that are financed by the U.S. shareholder with hybrid instruments.