Key takeaways
While nonprecedential, the Memorandum reflects the current IRS position on the question of whether a CFC can claim a DRD. The Memorandum therefore could have implications for taxpayers that own a minority stake in a specified 10-percent owned foreign corporation (SFC) through a CFC and have received dividends from the SFC. The IRS' publication of the GLAM presumably is intended to signal to taxpayers claiming a DRD in such fact patterns that these positions will now be challenged. While the Memorandum's rationale is questionable, taxpayers may still wish to evaluate the strength of their current tax positions in light of the Memorandum and determine whether any restructuring is warranted or updated opinions are needed to support their current structures.
In depth
The DRD, enacted as part of the Tax Cuts and Jobs Act (TCJA) in 2017, allows domestic corporations to deduct the foreign-source portion of dividends from certain foreign corporations in which they own at least 10%. Notwithstanding the statutory language which seemingly limits the DRD to domestic corporations, the legislative history to the TCJA indicated that Congress believed that the DRD would also apply to CFCs. H.R. Rep. No. 115-466, at 598-99 n.1486 (2017). In 2019, Treasury and the IRS announced that they were "study[ing] whether, and to what extent, proposed regulations should be issued that provide that dividends received by a CFC are eligible for a section 245A deduction." T.D. 9865 (June 18, 2019).
In ILM 202436010, the IRS addressed the non-taxpayer-specific fact pattern of a domestic corporation which wholly owns a CFC. The CFC in turn owns 45% of the single class of stock of a SFC. The CFC then receives a dividend from the SFC, and the question was whether the CFC was entitled to the DRD with respect to such dividend.
On these facts, the IRS concluded that the CFC was not eligible for the DRD. The IRS believed that the "plain language" of section 245A(a) limits the DRD to domestic corporations. The IRS contrasted the limiting language of section 245A with the more permissive language of sections 243 and 245 as examples of when Congress intends for a provision to apply to both domestic and foreign corporations. The IRS, however, proceeded to consider and address several arguments that taxpayers presumably have raised for extending the DRD to CFCs.
The first argument considered by the IRS was reading section 245A in light of the broader statutory framework, specifically sections 245A(e)(2) and 964(e)(4).
- Under section 245A(e)(2), a hybrid dividend received by a CFC from another CFC, where the same domestic corporation is a US shareholder of both, results in Subpart F income for the receiving CFC. A hybrid dividend is defined as an amount received from a CFC for which a deduction would be allowed under section 245A(a) "but for" section 245A(e). This provision could be read to suggest that Congress contemplated that CFCs would be entitled to the DRD, except in the case of hybrid dividends. The IRS, however, interpreted such language as merely definitional - Congress only meant to say that the provision is applicable if the recipient was a domestic corporation.
- Under section 964(e)(4)(A), the foreign-source portion of gain from the sale or exchange of stock by a CFC that is recharacterized as a dividend is treated as Subpart F income for the selling CFC. The US shareholder, however, may be allowed a DRD with respect to such amount. The argument under this provision is effectively a fairness argument - it would be "incongruous" to allow a DRD with respect to a deemed dividend received by a CFC but not an actual dividend. The IRS similarly disagreed with the premise and found the syllogism "asymmetrical and flawed" because section 964(e) does not apply to sales or exchanges of stock in foreign corporations that are not CFCs.
- Under section 964(e)(4)(B), rules similar to section 961(d) apply to the sale of stock by CFC. Section 961(d) provides that a domestic shareholder that received a dividend from an SFC must reduce its basis in the stock of such SFC by the amount of any DRD claimed. Thus, the argument would be that if the same basis reduction rule applies in both scenarios, section 245A should similarly apply. The IRS countered that section 964(e)(4)(B) does not depend on the application of section 245A to a CFC.
Although the IRS repeatedly refers to the "plain language" of section 245A(a) dictating the conclusion of the Memorandum, the IRS clearly strained to distinguish the "plain language" of several relevant statutory provisions that would suggest a contrary result.
The second argument considered by the IRS was the legislative history to the DRD which expressly indicated that Congress intended for the DRD to apply to CFCs. Footnote 1486 in the Conference Report provided that "a CFC receiving a dividend from a 10-percent owned foreign corporation that constitutes subpart F income may be eligible for the section 245A DRD." Although not cited in the Memorandum, the Joint Committee Report included a similar comment, but was even more strongly worded: "A corporate US shareholder of a CFC receiving a dividend from a 10-percent owned foreign corporation shall be allowed a DRD with respect to the subpart F inclusion attributable to such dividend in the same manner as a dividend would be allowable under section 245A." Joint Committee on Taxation, General Explanation of Public Law 115-97, JCS-1-18, at 348 (emphasis added).
The IRS dismissed this argument because the legislative history was contrary to the statutory language of section 245A(a), citing Supreme Court case law that a court must apply the statute as-written when the language is "clear and unambiguous." Such a position, however, is directly contrary to the IRS' own recent stance in situations where the plain language is taxpayer-favorable. For example, in the context of whether the DRD applied to the section 78 gross-up for fiscal year CFCs, the IRS readily disregarded the plain language of the effective date to, in its view, avoid "undermin[ing]" Congress' purported purpose of section 78. T.D. 9866 (June 19, 2019).
The final argument considered by the IRS stemmed from the same Conference Report footnote, which also cited Treas. Reg. § 1.952-2(b)(1) as support for its position of treating a CFC as a domestic corporation. Treas. Reg. § 1.952-2(b)(1) provides that a CFC's taxable income is calculated for Subpart F purposes by generally treating the CFC as a domestic corporation. The IRS pointed out that this rule is subject to an important limitation - certain provisions generally do not apply for purposes of this rule, including Subchapter N, which includes Subpart F and the definition of a US shareholder. Thus, a CFC cannot be treated as a US shareholder under Treas. Reg. § 1.952-2(b)(1). As a result, the IRS believed that Congress "missappl[ied]" Treas. Reg. § 1.952-2(b)(1) because a CFC would not be able to meet the requirements of section 245A(a) by virtue of this rule. The IRS further raised a "slippery slope" argument that any contrary interpretation would create "untenable results," such as allowing CFCs a section 250 deduction or allowing CFCs to be includible corporations for purposes of filing consolidated returns. While it is correct that the Subpart F provisions generally do not apply under this rule, this limitation is itself subject to a limitation: "except where otherwise distinctly expressed." Thus, arguably, when Congress weighed in with its explanation that CFCs could claim the DRD, such intent was "distinctly expressed" and narrowly circumscribed only to the DRD context, preventing any expansion more broadly to a section 250 deduction or inclusion in a consolidated return. The IRS unconvincingly attempted to rebut such a response by simply asserting that the legislative history "cannot reasonably be read" as such a distinct expression.
Conclusion
Seven years after the enactment of TCJA and section 245A, the Memorandum is a shot across the bow for taxpayers that sets out, in no uncertain terms, the IRS position that a CFC cannot claim a DRD. The IRS did its best to address the key arguments that taxpayers would have raised, but, as noted above, the IRS responses each suffer from various infirmities. The overall issue with the Memorandum is that it seems to ignore one of the fundamental objectives of TCJA, which was to encourage repatriations to the United States, and such repatriations should not be limited to first-tier foreign subsidiaries but also apply equally to multi-tier structures.
While an ILM is not binding precedent for either the IRS or a taxpayer, it nevertheless may have the intended result of taxpayers reconsidering any positions taken consistent with the ILM's facts. The IRS presumably will memorialize its position in future regulations, and, as with various other TCJA-related administrative guidance, may ultimately have to be resolved in court.
