United States: Treasury takes another swipe against transactions applying section 951(a)(2)(B)

Tax news and developments December 2022

In brief

On 9 December 2022, Treasury issued proposed regulations seeking to prevent a US shareholder from reducing its pro rata share of the subpart F and tested income of a controlled foreign corporation (CFC) through the operation of Code Section 951(a)(2)(B), when the components that would trigger the application of section 951(a)(2)(B) are: (i) a CFC-to-CFC distribution of previously taxed earnings and profits (PTEP) under section 959(b); and (ii) a change in direct or indirect US shareholder (a “Section 958(a) Shareholder”) that results from a change in ownership from one US consolidated group member to another.

In more detail

Below we provide a summary of the operation of section 951(a)(2)(B), how Treasury has regulated against the section 951(a)(2)(B) transactions it does not like, and how the proposed regulations would expand the range of such regulatory action. For an in depth analysis of the section 951(a)(2)(B) proposed regulations, please look for our article “Treasury Takes Another Bite Out of Section 951(a)(2)(B) in Prop. Reg. § 1.1502-80(j)” that will be published on 6 January 2023 in the Tax Management International Journal.

Section 951(a)(2)(B)

A section 958(a) Shareholder (“Final Section 958(a) Shareholder”) that holds, directly or indirectly, shares of a foreign corporation (the “Relevant Shares”) on the last day in the taxable year on which the entity is a CFC must determine its pro rata share of the subpart F and tested income of the CFC. Section 951(a)(2)(B) provides that the Final Section 958(a) Shareholder’s pro rata share is reduced when three conditions are satisfied. The first condition is that the Final Section 958(a) Shareholder must not have been the Section 958(a) Shareholder of the Relevant Shares during the entire taxable year of the CFC (“New Section 958(a) Shareholder Requirement”). Second, the CFC must make a dividend distribution during its taxable year (the “Dividend Requirement”). Third, the CFC’s dividend must be made to a person other than the Final Section 958(a) Shareholder (the “Other Person Requirement”).

Based on the rules for computing the amount of the pro rata share reduction, which are provided in section 951(a)(2)(B) and Treas. Reg. § 1.951-1(b)(1), when section 951(a)(2)(B) applies, it will often reduce the Final Section 958(a) Shareholder’s pro rata share of subpart F and tested income by the amount of the dividends distributed by the CFC to other persons when section 958(a) ownership of the CFC is transferred close to the end of the CFC’s taxable year and the CFC’s dividends to other persons do not exceed the sum of the CFC’s subpart F and tested income.

Treasury Actions Against Section 951(a)(2)(B) Transactions

The section 951(a)(2)(B) pro rata share reduction generally applies whether or not the dividend that satisfies the Dividend Requirement is subject to US tax. For example, consider a circumstance in which a US corporation, US 1, wholly owns CFC 1, and CFC 1 wholly owns CFC 2. During CFC 2’s taxable year, it has USD 110 of tested income (and no subpart F income), current year E&P of USD 110, and no other E&P. CFC 2 distributes a USD 100 dividend to CFC 1, and, on the day before the last day of CFC 2’s taxable year, CFC 1 transfers CFC 2 to US 2, a US corporation.

Based on these facts, US 1 would have no inclusion with respect to CFC 2’s tested income because US 1 was not a Section 958(a) Shareholder of CFC 2 on the last day of CFC 2’s taxable year. Additionally, section 951(a)(2)(B) would apply because all three of its requirements are satisfied. The New Section 958(a) Shareholder Requirement is satisfied because US 2 is a new Section 958(a) Shareholder. The Dividend Requirement is satisfied because CFC 2 has E&P that is distributed in a dividend described under section 301(c)(1). Finally, the Other Person Requirement is satisfied because CFC 1 and US 2 are different persons. Thus, generally speaking, under section 951(a)(2)(B) and Treas. Reg. 
§ 1.951-1(b)(1), US 2’s pro rata share of CFC 2’s tested income would be reduced by USD 100, from USD 110 to USD 10.

Furthermore, absent regulations to the contrary, CFC 2’s dividend (that satisfies the Dividend Requirement) would not be subject to tax as a result of the application of section 954(c)(6).

Unhappy with this result, and the similar result when section 245A(a) would apply to a distribution that satisfies the Dividend Requirement, Treasury issued regulations under section 245A that, generally speaking, prevent sections 245A(a) and 954(c)(6) from applying to a dividend, when the dividend causes a reduction in a US shareholder’s pro rata share of tested income or subpart F income under section 951(a)(2)(B). See Temp. Reg. §§ 1.245A-5T(e); 1.245A-5T(f) (2019); Treas. Reg. §§ 1.245A-5(e); 1.245A-5(f) (2020).

Prop. Reg. § 1.1502-80(j)

Because Treas. Reg. § 1.245A-5(e) and (f) only apply to turn off sections 245A(a) and 954(c)(6), it would not apply in the fact pattern above if CFC 2 had USD 100 of PTEP. In that case, CFC 2’s distribution would be a distribution of PTEP to a CFC, which, generally speaking, is a dividend that satisfies the Dividend Requirement. Section 959(d) provides that a section 959(a) distribution of PTEP to a US shareholder is not treated as a dividend, but says nothing about a section 959(b) distribution of PTEP to a CFC. Thus, generally speaking, CFC 2’s distribution is a tax-free distribution of PTEP to CFC 1, and section 951(a)(2)(B) still applies to reduce US 2’s pro rata share of CFC 2’s tested income.

The proposed regulations seek to alter that outcome when US 1 and US 2 are members of a US consolidated group, by treating members of a consolidated group as a single US shareholder solely for the purpose of determining the section 951(a)(2)(B) pro rata share reduction when the application of section 951(a)(2)(B) is triggered by a CFC-to-CFC distribution of PTEP under section 959(b). Thus, if US 1 and US 2 are members of a consolidated group and the distribution from CFC 2 to CFC 1 is a distribution of PTEP, the proposed regulations would seek to prevent section 951(a)(2)(B) from applying by causing the transaction to fail the New Section 958(a) Shareholder Requirement.

The proposed regulations have an unusual effective date and apply to taxable years of a consolidated group for which the original consolidated return is due (without extensions) after the final regulations are published. Comments to the proposed regulations are due by 18 January 2023.

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