Repeal of the Limitation on Downward Attribution, Form 5471 and Safe Harbors from Rev Proc 2019-40

Soon after the Tax Cuts and Jobs Act was enacted in 2017, the problems caused by the repeal of section 958(b)(4), commonly referred to as a limitation on the downward attribution of stock ownership from foreign to U.S. persons, became increasingly apparent. 

Defining Key Terms For Understanding the Attribution Rules and Form 5471

U.S. Person

Only U.S. persons can have a Form 5471 filing obligation. A U.S. person is generally a citizen or resident of the United States, a domestic partnership, a domestic corporation, or a domestic trust or estate as defined by Section 7701(a)(30). A tax-exempt U.S. entity may have a Form 5471 filing obligation.

U.S. Shareholder

Internal Revenue Code Section 951(b) defines a “U.S. shareholder” as a U.S. citizen, resident alien, corporation, partnership, trust or estate, owning directly, indirectly or constructively under the ownership rules of Section 958, ten percent or more of the total combined voting power of all classes of stock of a foreign corporation or the value of all the outstanding shares of a foreign corporation.

Controlled Foreign Corporation (“CFC”)

A foreign corporation is a CFC if, on any day during the foreign corporation’s taxable year, U.S. shareholders own more than 50 percent of the combined voting power of all classes of stock, or more than 50 percent of the total value, of the foreign corporation. Only U.S. shareholders are considered in applying for the 50 percent test. All forms of ownership, including direct, indirect (ownership through intervening entities), and constructive (attribution of ownership from one related party to another), are considered in applying the 50 percent test.

Section 965 Specified Foreign Corporation (“SFC”)

An SFC is a foreign corporation that is either a CFC or has at least one U.S. shareholder that is a corporation. In other words, the term SFC includes not only CFCs, but also entities commonly referred to as 10/50 companies. These foreign companies have at least one U.S. shareholder, but are not CFCs because U.S. shareholders do not own more than 50 percent of the entity by vote or value.

Form 5471 Filing Requirements

A Form 5471 and schedules must be completed and filed by certain categories of filers discussed below.

Category 1 Filer

A Category 1 filer is a U.S. shareholder of a SFC at any time during any taxable year of the SFC who owned that stock on the last day in that year on which it was an SFC. A SFC is a CFC, or any foreign corporation with one or more 10 percent domestic corporation shareholders.

Category 2 Filer

A Category 2 filer is a U.S. citizen or resident who is an officer or director of a foreign corporation in which there has been a change in substantial U.S. ownership – even if the change relates to stock owned by a U.S. person who is not an officer or director. A substantial change in U.S. ownership is when any U.S. person (not necessarily the U.S. citizen or resident who is the officer or director) acquires stock that causes him or her to own a 10 percent block, or acquires an additional 10 percent block, of stock in that corporation. More precisely, if any U.S. person acquires stock, which, when added to any stock previously owned, causes him or her to own stock meeting the 10% stock ownership requirement, the U.S. officers and directors of that foreign corporation must report. A disposition of shares in a foreign corporation by a U.S. person does not create filing obligations under Category 2 for U.S. officers and directors. Stock ownership is a vote or value test.

Category 3 Filer

A U.S. person is a Category 3 filer with respect to a foreign corporation for a year if the U.S. person does any of the following during the tax year:

  1. Acquires stock in the corporation, which, when added to any stock owned on the acquisition date, meets the Category 2 filer 10 percent stock ownership requirement.
  2. Acquires additional stock that meets the 10 percent stock ownership requirement.
  3. Becomes a U.S. person while meeting the 10 percent stock ownership requirement.
  4. Disposes of sufficient stock in the corporation to reduce his or her interest to less than 10 percent stock ownership requirement.
  5. Meets the 10 percent stock ownership requirement with respect to the corporation at a time when the corporation is reorganized.

Stock ownership is a vote or value test. Section 958 applies direct, indirect, and constructive ownership rules to determine stock ownership in the foreign corporation. These ownership rules require attribution of stock between certain family members, such as brothers or sisters, spouse, ancestors, and lineal descendants and between corporations, partnerships, trusts and estates. These attribution rules fall into the following four categories.

  1. Family Attribution. An individual is considered as owning stock owned by his spouse, children, grandchild, and parents. Siblings and inlaws are not part of the “family” for this purpose, and there is no attribution from grandparent to a grandchild.
  2. Entity Beneficiary Attribution. Stock owned by or for a partnership or estate is considered owned by the partners or beneficiaries in proportion to their beneficial interests. A person ceases to be a “beneficiary” of an estate for this purpose when he receives all property to which he is entitled and the possibility he must return the property to satisfy claims is remote. Stock owned by a trust is considered owned by the beneficiaries in proportion to their actuarial interests in the trust. In the case of grantor trusts, stock is considered owned by the grantor or other person who is taxable on the trust income. Stock owned by a corporation is considered owned proportionately (comparing the value of the shareholder’s stock to the value of all stock) by a shareholder who owns, directly or through the attribution rules, 50 percent or more in value of that corporation’s stock.
  3. Beneficiary to Entity Attribution. Stock owned by partners or beneficiaries of an estate is considered as owned by the partnership or estate. All stock owned by a trust beneficiary is attributed to the trust except where the beneficiary’s interest is “remote” and “contingent.” Grantor trusts are considered to own stock owned by the grantor or other person taxable on the income of the trust.
  4. Option Attribution. A person holding an option to acquire stock is considered as owning that stock.

Category 4 Filer

A U.S. person is a Category 4 filer with respect to a foreign corporation for a taxable year if the U.S. person controls the foreign corporation. A U.S. person is considered to control a foreign corporation if at any time during the person’s taxable year, such person owns: 1) stock possessing more than 50 percent of the total combined voting power of all classes of stock entitled to vote; or 2) more than 50 percent of the total value of shares of all stock of the foreign corporation. For Category 4 purposes, U.S. persons include those individuals who make a Section 6013(g) or (h) election to be treated as resident aliens of the United States for income tax purposes.

The constructive ownership rules discussed above are applied to determine if the U.S. person “controls” the foreign corporation.

Category 5 Filer

A Person is a Category 5 filer if the person: 1) is a U.S. shareholder of a CFC at any time during the CFC’s taxable year; and 2) owns stock of the foreign corporation on the last day in the year in which that corporation is a CFC. For category 5 purposes, constructive ownership is determined under Section 318 (discussed above) as modified by Section 958(b). Pursuant to Section 958(b), there is no attribution from a nonresident alien relative.

New Categories

Categories 1 and 5 have been expanded to 1a, 1b, 1c, 5a, 5b, and 5c in order to separate those filers who are under some relief and may not need to file the same schedules.These new categories will distinguish those 5471 filers who only need to file a Form 5471 due to downward attribution caused by the repeal of Section 958(b)(4) and will therefore not be required to attach certain schedules to their Form 5471s.

Category 1a filer is one who is not defined as a Category 1b or Category 1c filer. Thus, a Category 1a filer is anyone who is greater than 50 percent owner of an SFC.

Category 1b filer is an unrelated Section 958(a) U.S. shareholder. A Category 1b filer is an unrelated person who would not control (more than 50% vote or value) the SFC or be controlled by the same person which controls the SFC.

Category 1c filer is a related constructive U.S. shareholder. A Category 1c filer is typically an entity controlled by (more than 50% vote or value) the same person which controls the SFC and files only due to this downward attribution.

Category 5a filer is one who is not defined as a Category 5b or a Category 5c filer. Thus, a Category 5a filer is anyone who is greater than 50 percent owner of CFC.

Category 5b filer is an unrelated Section 958(a) U.S. shareholder. A Category 5b filer is an unrelated person who would not control (more than 50% vote or value) the CFC or be controlled by the same person which controls the CFC.

Category 5c filer is a related constructive U.S. shareholder. A Category 5c filer is typically an entity controlled by (more than 50% vote or value) the same person which controls the CFC and files only due to this downward attribution.

I. Section 958(b)(4) Before the TCJA

A U.S. shareholder of a controlled foreign corporation must include in gross income its pro rata share of subpart F income and tested income (which is used in computing the U.S. shareholder’s global intangible low-taxed income). CFC status is also relevant for several other code and regulatory provisions outside subpart F.

In determining U.S. shareholder status and CFC status, ownership is defined in two ways. First, section 958(a) defines ownership as direct ownership and indirect ownership through foreign entities. Stock owned directly or indirectly by or for a foreign corporation, foreign partnership, foreign trust, or foreign estate is considered as being owned proportionately by its shareholders, partners, or beneficiaries. Only U.S. shareholders that own CFC stock within the meaning of section 958(a) have a subpart F income or GILTI inclusion. Second, section 958(b) provides constructive ownership rules and defines ownership by reference to the constructive ownership rules in section 318(a), as modified by section 958(b).

Before its repeal, section 958(b)(4) provided that section 318(a)(3)(A) through (C) would not be applied to consider a U.S. person as owning stock owned by a person that is not a U.S. person. Section 318(a)(3)(A) through (C) provides the following rules for downward attribution for partnerships, estates, trusts, and corporations:

  • Stock owned directly or indirectly by or for a partner or a beneficiary of an estate is considered owned by the partnership or estate. Note that there is no ownership threshold for this rule. Thus, for example, if a partner has only a 1 percent interest in a partnership, that partnership is treated as owning all the stock owned by the partner.
  • Stock owned directly or indirectly by or for a beneficiary of a trust is generally considered owned by the trust, unless the beneficiary’s interest in the trust is a remote contingent interest. Also, stock owned directly or indirectly by or for a person that is considered the owner of any portion of a trust under the grantor trust rules is considered owned by the trust.
  • If 50 percent or more in value of the stock in a corporation is owned directly or indirectly by or for any person, that corporation is considered as owning the stock owned by or for that person.

Under a simple base case example (Example 1), assume that a foreign parent corporation (FP) wholly owns a U.S. subsidiary (US Sub) and a foreign subsidiary (Foreign Sub). Foreign Sub does not have any section 958(a) U.S. shareholders, because no U.S. shareholders own a direct or indirect interest in Foreign Sub.

Under sections 958(b) and 318(a)(3)(C), because FP owns 50 percent or more of the stock in US Sub, US Sub is treated as owning the stock owned by FP, which includes 100 percent of the stock of Foreign Sub. Former section 958(b)(4) avoided this result by preventing a U.S. person (in this case, US Sub) from being attributed stock owned by a foreign person (in this case, FP).

II. Repeal and Consequences

The section 958(b)(4) limitation on downward attribution was repealed by the TCJA, effective for the last tax year of a foreign corporation beginning before January 1, 2018.

However, despite statements in the legislative history indicating that Congress intended to limit the scope of section 958(b)(4) repeal, section 958(b)(4) was simply stricken from the code. As discussed below, the lack of a limitation on downward attribution from foreign to U.S. persons can have far-reaching effects, expanding the scope of U.S. shareholder and CFC status, including in situations quite different from those discussed in the legislative history.

One common situation in which “new” CFCs arise involves subsidiary corporations being deemed to own interests in brother-sister entities through application of the downward attribution in section 318(a)(3). For example, after the repeal of section 958(b)(4), the result in Example 1 changes because there is no longer a limitation on the attribution of stock owned by FP to US Sub under section 318(a)(3)(C). As a result, because US Sub would be considered to own 100 percent of the stock of Foreign Sub, Foreign Sub would be a CFC, and US Sub would be a U.S. shareholder of Foreign Sub.

Thus, U.S. subsidiaries may be treated as owning other foreign entities in the structure, greatly increasing the number of foreign corporations treated as CFCs. Although the TCJA did not change the calculation of a U.S. shareholder’s pro rata share of subpart F income or tested income (which is still determined based on direct or indirect ownership of the CFC under section 958(a)), the repeal of section 958(b)(4) has resulted in numerous apparently unintended consequences, including income inclusions by some ultimate U.S. investors that would not have had income inclusions before the repeal, and additional compliance burdens for those U.S. investors.

Unexpected consequences after the repeal of section 958(b)(4) can also occur with a lower-tier domestic partnership. Suppose that US Sub is treated as a partnership rather than a corporation for U.S. tax purposes and that FP has a 1 percent interest in US Sub. Section 318(a)(3)(A) provides that a partnership is treated as owning the stock owned by its partners, and there is no minimum ownership threshold for the application of that rule. Consequently, US Sub would be treated as owning all the stock owned by FP, even though FP has only a 1 percent interest in US Sub. This would cause Foreign Sub to be treated as a CFC and US SH to have an income inclusion, as illustrated in Example 3.

The collateral damage from section 958(b)(4) repeal extends to other contexts. One of them is the portfolio interest exemption, which is often relied on in financing structures connected to U.S. investments made by foreign individuals. The portfolio interest exemption exempts from tax most U.S.-source portfolio interest received by a foreign corporation. Portfolio interest generally includes interest paid on a debt obligation that is in registered form, but it excludes interest received by a CFC from a related person (defined as (1) a related person within the meaning of section 267(b); and (2) any U.S. shareholder of the CFC, and any person that is a section 267(b) related person to that U.S. shareholder) As a result of the repeal of section 958(b)(4), interest payments arising from some financing structures no longer qualify for the portfolio interest exemption.

CFC status is also relevant under numerous other code sections outside subpart F, including sections 267, 332, 367, 672, 706, 863, 904, 1248, 1297, and 6049. The repeal of section 958(b)(4) affects the application of these rules and results in unexpected consequences. Further, U.S. shareholders of CFCs are subject to information reporting requirements on Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” The section 958(b)(4) repeal causes some U.S. persons to have a filing requirement when they did not have one before the enactment of the TCJA.

Note that the classification of a foreign corporation as a CFC, or a U.S. person as a U.S. shareholder, can be advantageous in some situations. For example, the section 245A dividends received deduction may apply to dividends from a CFC; section 1248 may apply to recharacterize gain from the sale of a CFC as a dividend; and the status of a foreign entity as a CFC could prevent it from being treated as a passive foreign investment company for some U.S. shareholders. Moreover, some anticipated that payments to CFCs from certain foreign corporations treated as CFCs as a result of the repeal of section 958(b)(4) could qualify for the section 954(c)(6) look-through rule, although Treasury and the IRS have issued proposed regulations that would prevent that result.

As detailed in Section III, some of the apparently unintended issues created by the repeal of section 958(b)(4) have been addressed in guidance. However, as discussed in Section IV, other problems likely require a statutory fix.

III. Treasury and IRS Response

The targeted response by Treasury and the IRS suggests that they do not believe they have the authority to broadly limit the impact of the repeal of section 958(b)(4) and that some of the fundamental issues raised by the repeal will need to be addressed by Congress. Relief has been focused on addressing specific unintended outcomes.

A. Notice 2018-13 and Notice 2018-26

In 2018 the IRS issued Notice 2018-13, 2018-6 IRB 341, and Notice 2018-26, 2018-16 IRB 480, which provided some temporary relief in limited circumstances when section 958(b)(4) repeal caused unintended consequences.

Notice 2018-13 addressed the effect of the repeal on the application of the source rules under section 863(d) and (e) (which address gross income from space and ocean activities and income from international communications) and some reporting issues. Regarding section 863(d) and (e), some source rules turn on whether the income is derived by a CFC. Notice 2018-13 indicated that further study was necessary to determine whether it is appropriate for the source of income described in section 863(d) and (e) to be determined by reference to CFC status, and it provided that, pending further guidance, taxpayers could determine CFC status without regard to the repeal of section 958(b)(4) for purposes of those rules. (Final regulations issued in 2020 later addressed these sourcing issues, as discussed in Section III.C.2.g.)

Notice 2018-13 also stated that the IRS intended to amend the instructions for Form 5471 to provide an exception from category 5 filing for a U.S. person that is a U.S. shareholder of a CFC if no U.S. shareholder owns (within the meaning of section 958(a)) stock in that CFC and the foreign corporation is a CFC solely because that U.S. person is considered to own the stock of the CFC owned by a foreign person under section 318(a)(3). Thus, in Example 1, US Sub would not be required to file Form 5471 for FP, because US Sub does not own section 958(a) stock in FP, and FP is a CFC solely because US Sub is considered to own the FP stock owned by Foreign Sub under section 318(a)(3).

In Notice 2018-26, the IRS acknowledged that as a result of the repeal of section 958(b)(4) and the application of the constructive ownership rules in section 318(a)(3), it may be difficult to determine if a foreign corporation is a specified foreign corporation under section 965 in some circumstances. For example, assume that a person (A) owns 100 percent of the stock of a U.S. corporation (USCo) and 1 percent of the interests in a partnership (PS). A U.S. citizen (USI) owns 10 percent of the interests in PS and 10 percent by vote and value of the stock of a foreign corporation (ForCo). The remaining stock of ForCo is owned by non-U.S. persons unrelated to A, USCo, USI, or PS.

Under sections 958(b) and 318(a)(3)(A), PS would be treated as owning 100 percent of the stock of USCo and 10 percent of the stock of ForCo. As a result, under sections 958(b) and 318(a)(3)(A) and (C), USCo would be treated as owning the stock of ForCo that is treated as owned by PS and thus would be a U.S. shareholder of ForCo. That would cause ForCo to be a specified foreign corporation as defined under section 965(e)(1)(B) (which includes a foreign corporation in which one or more domestic corporations is a U.S. shareholder). USI would be a U.S. shareholder of ForCo and, absent an exception, would be subject to the transition tax for ForCo. In that situation, it may be difficult for USI to obtain the necessary information from PS, A, and USCo to determine whether ForCo is a specified foreign corporation.

Notice 2018-26 announced Treasury and the IRS’s intent to issue regulations to provide guidance on this matter. Proposed regulations were issued August 1, 2018, and finalized January 15, 2019. The final regulations provide that in determining whether a foreign corporation is a specified foreign corporation within the meaning of section 965(e)(1)(B), stock owned directly or indirectly by or for a partner will not be considered to be owned by a partnership under the constructive ownership rules of sections 958(b) and 318(a)(3)(A) and reg. section 1.958-2(d)(1)(i) if the partner owns less than 10 percent of the interests in the partnership’s capital and profits.

B. Rev. Proc. 2019-40

Treasury and the IRS issued more extensive guidance on October 1, 2019, with the release of proposed regulations and Rev. Proc. 2019-40, 2019-43 IRB 982. As discussed below, the proposed regulations were largely finalized September 21, 2020 (except for some rules concerning PFICs, for which a preliminary version of final regulations was released December 4, 2020), and new proposed regulations were issued concurrently.

Rev. Proc. 2019-40 provides relief from some information reporting requirements. It also provides three safe harbors for determining whether a foreign corporation is a CFC and for determining particular items of a CFC (such as taxable income and earnings and profits) based on alternative information. Relief is generally limited to U.S. shareholders of foreign-controlled CFCs, which are foreign corporations that would not be CFCs if the limitation on downward attribution under former section 958(b)(4) was applied. The revenue procedure also states that penalties under section 6038 (failure to furnish information) and section 6662 (underpayment) will not be applied if taxpayers satisfy specified requirements.

The first safe harbor (the safe harbor for determining CFC status) provides relief for U.S. owners of foreign entities that are unable to obtain sufficient information to determine the CFC status of those entities. The IRS will accept a U.S. person’s determination that a foreign corporation is not a CFC for the U.S. person if:

  • the U.S. person does not have actual knowledge, statements received, or reliable, publicly available information sufficient to determine whether the foreign corporation meets the section 957 ownership requirements; and
  • the U.S. person directly owns stock of, or an interest in, a foreign entity (top-tier entity), and the U.S. person inquires of the top-tier entity:
    • whether the top-tier entity meets the section 957 ownership requirements;
    • whether, how, and to what extent the top-tier entity directly or indirectly owns stock of one or more foreign corporations; and
    • whether, how, and to what extent the top-tier entity directly or indirectly owns stock of, or an interest in, one or more domestic entities.

The second safe harbor (the general safe harbor for using alternative information) provides relief for some unrelated section 958(a) U.S. shareholders of foreign-controlled CFCs. An unrelated section 958(a) U.S. shareholder is a section 958(a) U.S. shareholder that is not a related person for a foreign corporation, whereas a related section 958(a) U.S. shareholder is a section 958(a) U.S. shareholder that is a related person for a foreign corporation. (The term “related person” is defined by reference to the relatedness thresholds of section 954(d)(3).) Under this safe harbor, in the case of a foreign-controlled CFC for which there is no related section 958(a) U.S. shareholder, an unrelated section 958(a) U.S. shareholder may determine the taxable income and E&P of the CFC (and comply with related information reporting requirements) using specified alternative information. The revenue procedure provides a hierarchical list of the alternative information that can be used, which consists of various types of separate-entity audited financial statements, followed by types of separate-entity unaudited financial statements, and then some separate-entity internal records.

The third safe harbor (the safe harbor for using alternative information for determining section 965 amounts) provides relief for some U.S. owners determining particular items of a specified foreign corporation (within the meaning of section 965(e) and reg. section 1.965-1(f)(45)) based on alternative information. Under the safe harbor, for a specified foreign corporation — other than either a foreign-controlled CFC for which there is a related section 958(a) U.S. shareholder or a U.S.-controlled CFC (that is, a CFC other than a foreign-controlled CFC) — a section 965 amount may be determined by a section 958(a) U.S. shareholder based on alternative information if the information required under the regulations is not readily available.

Rev. Proc. 2019-40 also describes modifications to be made regarding the filing requirements for Form 5471. Taxpayers may generally rely on the safe harbors and penalty relief provisions of the revenue procedure for the last tax year of a foreign corporation beginning before January 1, 2018, and each subsequent tax year of the foreign corporation, and for the tax years of U.S. shareholders in which and with which the tax year of the foreign corporation ends. Rev. Proc. 2019-40 indicates that Treasury and the IRS may update the guidance as needed to ensure adequate tax compliance, but any updates would be prospective.

C. Final Regulations

1. Nov. 2019 final regulations.

On November 18, 2019, Treasury and the IRS issued final regulations that provided guidance on the targeted issue of determining whether a person is related to a CFC under section 954(d)(3). Section 954(d)(3) provides that a person is a related person with respect to a CFC if the person is (1) an individual who controls the CFC; (2) a corporation, a partnership, a trust, or an estate that controls or is controlled by the CFC; or (3) a corporation, a partnership, a trust, or an estate that is controlled by the same person or persons that control the CFC. For a corporation, control means the direct or indirect ownership of stock possessing more than 50 percent of (1) the total voting power of all classes of stock entitled to vote or (2) the total value of stock of the corporation. The section 958 rules for determining direct, indirect, and constructive stock ownership apply for purposes of section 954(d)(3) to the extent that the effect is to treat a person as a related person within the meaning of section 954(d)(3).

The determination of whether specific types of sales and services income constitute foreign base company income depends in part on whether the income is earned from a transaction that involves a related person, as defined under section 954(d)(3). Also, the definition of related person under section 954(d)(3) is relevant in determining whether particular income qualifies for an exception to foreign personal holding company income. Treasury and the IRS determined that following section 958(b)(4) repeal, the application of the section 318(a)(3) constructive ownership rules for purposes of the section 954(d)(3) definition of related person could inappropriately treat entities, including CFCs, that do not have a significant relationship to each other as related persons.

Consistent with proposed regulations issued on May 17, 2019, the final regulations provide that for purposes of section 954(d)(3), neither section 318(a)(3) nor reg. section 1.958-2(d) applies to cause downward attribution of stock or other interests to a corporation, partnership, estate, or trust. Subject to an antiabuse rule, this rule generally applies to tax years of CFCs ending on or after November 19, 2019, and tax years of U.S. shareholders in which or with which those tax years end.

2. Sept. 2020 final regulations.

a. Overview.

On September 21, 2020, Treasury and the IRS issued final regulations addressing several targeted issues, generally consistent with the proposed regulations released on October 1, 2019. The final regulations modify the constructive ownership regulations under section 958 to be consistent with the repeal of section 958(b)(4). Further, the final regulations attempt to limit the collateral damage resulting from the repeal by making modifications to ensure that the operation of specific rules outside subpart F are consistent with their application before the repeal.

While some of these changes are favorable to taxpayers, others focus on preventing taxpayers from claiming what the government views as inappropriate benefits. What these rules have in common is that either (1) the relevant statutory provisions generally contain specific regulatory authority to exclude particular transactions or otherwise modify the application of the rules in some situations, or (2) the relevant regulatory provisions were promulgated before the repeal of section 958(b)(4) and assume that the limitation on downward attribution and the relevant rule could operate materially differently after section 958(b)(4) repeal. The final regulations do not change the operation of section 958(b)(4) repeal in the subpart F context. Thus, for example, CFCs whose U.S. owners have income inclusions after the repeal of section 958(b)(4) will continue to have those income inclusions.

The final regulations generally apply on or after October 1, 2019. For prior tax years, if the taxpayer and related U.S. persons apply the relevant rule consistently for all foreign corporations, a taxpayer may generally apply the final regulations to (1) the last tax year of a foreign corporation beginning before January 1, 2018, and each subsequent tax year, and (2) tax years of U.S. shareholders in which or with which those tax years of the foreign corporation end.

b. Section 267(a)(2).

Section 267(a)(2) provides a general matching rule that governs the time at which an otherwise deductible amount owed to a related person may be deducted. Specifically, it provides that, for specified interest and expenses paid by the taxpayer to a related person, if an amount is not includable in the payee’s gross income until it is paid, the amount generally is not allowable as a deduction to the taxpayer until the amount is includable in the gross income of the payee.

A foreign payee rule provides that, subject to some exceptions, a taxpayer must use the cash method of accounting for deductions of amounts owed to a related foreign person. However, under a special CFC payee rule, an item payable to a CFC is deductible by the payer before the year of payment only to the extent includable in the gross income of a section 958(a) U.S. shareholder (that is, a U.S. shareholder with a direct or indirect interest in the CFC). After section 958(b)(4) repeal, a foreign entity could be treated as a CFC but not have any section 958(a) U.S. shareholders that might include that payment in gross income.

The final regulations provide that an amount that is income of a related foreign person is not subject to the CFC payee rule if the related foreign person is a CFC that has no section 958(a) U.S. shareholders. The proposed regulations would have limited the exception to amounts (other than interest) of income of a related foreign person exempt from U.S. taxation under a treaty obligation when the related foreign person was a CFC without section 958(a) U.S. shareholders. The exception from the CFC payee rule in the final regulations thus expands on the proposed regulations by applying to all amounts payable to a related person that is a CFC that has no section 958(a) U.S. shareholders. Instead, the foreign payee rule and the related exceptions to the foreign payee rule under the regulations will apply to those payments. Note, however, that the CFC payee rule continues to apply to a CFC that has a section 958(a) U.S. shareholder, even if the foreign corporation is a CFC solely as a result of section 958(b)(4) repeal.

c. Section 332(d)(1).

Section 332(a) provides generally that no gain or loss shall be recognized on the receipt by a corporation of property distributed in complete liquidation of another corporation. There are some exceptions to this nonrecognition rule for distributions made by domestic corporations to foreign corporations. Under section 332(d)(1), a distributee foreign corporation recognizes income from the liquidation of some domestic holding companies (applicable holding companies) by treating the liquidating distribution as a dividend under section 301, which would generally be subject to a 30 percent withholding tax. However, section 332(d)(3) provides that exchange treatment under section 331 applies if the distributee corporation is a CFC. The gain on the distribution could be subpart F income, and before the repeal of section 958(b)(4), CFCs generally had U.S. shareholders that would be subject to tax on their share of the gain.

After the repeal of section 958(b)(4), the section 332(d)(3) exchange treatment exception could apply in situations in which a foreign corporation is a CFC as a result of downward attribution and does not have any U.S. shareholders that would have a current income inclusion. 

Treasury and the IRS determined that this was an inappropriate result because any gain recognized on the exchange of stock of US Sub 2 by Foreign Sub could avoid U.S. tax, since Foreign Sub does not have any U.S. shareholders that have current income inclusions. Thus, the final regulations modify the section 332 regs to provide that in applying section 332(d)(3), CFC status is determined without regard to downward attribution from foreign persons. As a result, the liquidation of US Sub 2 would be subject to section 301 treatment for Foreign Sub under section 332(d)(1).

d. Section 367(a).

Section 367(a) overrides the nonrecognition provisions of section 332, section 351, and other code provisions for outbound transfers by a U.S. person to a foreign corporation by providing that the foreign corporation is not treated as a corporation for purposes of the nonrecognition provisions. This generally denies nonrecognition treatment to transfers of property subject to section 367(a) on which gain is realized, unless an exception applies. One exception provides that section 367(a) does not apply to specified transfers of stock or securities of a foreign corporation by a U.S. transferor if the U.S. transferor enters into a gain recognition agreement (GRA) for the transferred stock or securities.

Under the GRA, the U.S. transferor agrees to include in income the gain realized on the transfer of the stock upon triggering events. A disposition of the stock or securities by the foreign corporate transferee is generally a triggering event, but not if the disposition qualifies as a nonrecognition transaction and the U.S. transferor meets specified requirements immediately after the disposition, including owning 5 percent or more of the vote and value of the foreign corporation’s stock. Ownership for these purposes is determined by applying section 318 as modified by section 958(b).

After section 958(b)(4) repeal, U.S. taxpayers could satisfy the 5 percent ownership requirement without directly or indirectly owning the foreign transferee’s stock. Thus, the final regulations provide that the GRA triggering event exception determines ownership without applying downward attribution to consider the U.S. transferor as owning stock owned by a foreign person.

e. Section 672.

Section 672(f)(1) generally provides that the grantor trust rules in sections 671 through 679 apply only to the extent they result in income being currently taken into account by a U.S. citizen or resident or a domestic corporation. Section 672(f)(3)(A) provides a special rule that, except as otherwise provided by regulations, 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 under section 957, determined without applying section 318(a)(3)(A), (B), and (C) to consider a U.S. person as owning stock that is owned by a non-U.S. person.

f. Section 706.

Section 706 contains rules for determining the tax year of a partnership and its partners. Reg. section 1.706-1(b)(6) provides that specified interests held by foreign partners are not considered in determining the tax year. For this purpose, CFCs are not treated as foreign partners. After section 958(b)(4) repeal, a foreign corporation that is a CFC solely because of downward attribution may be taken into account in determining a partnership’s tax year, even if the CFC does not have a section 958(a) U.S. shareholder that has a current income inclusion.

Under the final regulations, the definition of foreign partner excludes only CFCs for which a U.S. shareholder owns stock within the meaning of section 958(a) for purposes of determining a partnership’s tax year.

g. Section 863.

As mentioned in the discussion of Notice 2018-13, some source rules turn on whether the income is derived by a CFC. Section 863 provides rules for determining the source of some items of gross income, including gross income from space and ocean activities and income from international communications. Unless an exception applies, any income derived from a space or ocean activity by a U.S. person is U.S.-source income, while any space and ocean income derived by a foreign person is foreign-source income. However, space and ocean income derived by a CFC is treated as U.S.-source income, except to the extent that the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in a foreign country.

International communications income is defined as all income derived from the transmission of communications or data from the United States to any foreign country (or possession of the United States), or from any foreign country (or possession of the United States) to the United States. Any international communications income derived by a U.S. person is treated as half U.S.-source income and half foreign-source income. Generally, international communications income derived by a foreign person is treated as foreign-source income. However, international communications income derived by a CFC is treated as half U.S.-source income and half foreign-source income.

After section 958(b)(4) repeal, a CFC’s income from space and ocean activities and from international communications may be treated as U.S.-source income, even if the CFC has no section 958(a) U.S. shareholders that might include that income in gross income. Under the final regulations, CFC status for purposes of these rules is determined without regard to downward attribution from foreign persons.

h. Section 904.

Generally, section 904(a) limits the amount of foreign income taxes that a taxpayer may claim as a credit against its U.S. income tax based on the U.S. tax imposed on the taxpayer’s foreign-source income. Section 904(d) further limits the credit by category of foreign-source income. After tax reform under the TCJA, the categories (or baskets) are general, passive, foreign branch, and GILTI.

Some of the rules used to categorize income into baskets turn on whether an amount is paid or earned by a CFC. Passive category income includes income that would be foreign personal holding company income under section 954(c) (for example, dividends, interest, rents, and royalties). However, under a look-through rule, if that income is received by a U.S. shareholder from a CFC, the income is passive category income only to the extent allocable to passive category income of the CFC.With the repeal of section 958(b)(4), a payment by a foreign entity that otherwise would be considered passive income for a recipient U.S. shareholder could be eligible for the look-through rule because the paying entity is considered a CFC. The final regulations thus restrict the application of the look-through rule to entities that are CFCs determined without applying downward attribution.

Rents and royalties received by a CFC are generally passive category income unless derived in the active conduct of a trade or business (taking into account activities of affiliated group members), in which case rents and royalties are treated as general category income. Financial services income received by specific CFCs or a domestic corporation is treated as general category income. According to the preamble to the proposed regulations, both those rules are premised on the assumption that income of CFCs would be subject to U.S. tax under the subpart F rules or upon a distribution of E&P generated by that income, and that those CFCs would be directly or indirectly controlled by U.S. shareholders able to obtain information concerning the CFCs’ activities, income, and expenses. The final regulations revise the regulations under section 904 to limit the application of the affiliated group rules in the section 904 exception for active rents and royalties and the financial services income rule to recipient foreign corporations that are CFCs without regard to downward attribution from foreign persons, and to U.S. shareholders that are U.S. shareholders without regard to downward attribution from foreign persons.

i. Section 6049.

Under section 6049, a payer must report to the IRS on Form 1099 specified payments or transactions concerning U.S. persons that are not exempt recipients. The scope of payments or transactions subject to reporting depends in part on whether the payer is a U.S. payer.

A U.S. payer generally includes U.S. persons and their foreign branches, as well as CFCs.

After section 958(b)(4) repeal, foreign corporations that became CFCs solely because of downward attribution from foreign persons could be subject to an increased burden from these reporting requirements, even if they have no direct or indirect U.S. owners. Accordingly, the final regulations provide that a U.S. payer includes a CFC under section 957, determined without regard to downward attribution from foreign persons.

3. Dec. 2020 final PFIC regulations.

A preliminary version of the final PFIC regulations was released December 4, 2020. The regulations finalized the portion of the October 2019 proposed regulations modifying the definition of a CFC for purposes of the PFIC asset test under section 1297(e).

A foreign corporation is treated as a PFIC if the corporation’s average percentage of assets (as determined under section 1297(e)) held by the corporation during the tax year that produce passive income or are held for the production of passive income is at least 50 percent. Section 1297(e) provides the rules used to measure a foreign corporation’s assets in determining whether the foreign corporation meets this asset test and is therefore a PFIC. If the foreign corporation is a CFC and not a publicly traded corporation, when determining whether the average percentage of assets of the corporation that produce passive income is at least 50 percent, adjusted basis (rather than value) of the assets must be used.

This rule imposes a burden on taxpayers that own stock in foreign corporations that became CFCs solely by reason of section 958(b)(4) repeal, because those CFCs may not otherwise be required to account for adjusted basis in assets under federal income tax rules. Thus, the final regulations modify the definition of CFC for this purpose to disregard downward attribution from foreign persons. This rule generally applies to shareholder tax years ending on or after October 1, 2019. For tax years of shareholders ending before October 1, 2019, a shareholder may apply this rule to the last tax year of a foreign corporation beginning before January 1, 2018, and each subsequent tax year of the foreign corporation, if the shareholder and related U.S. persons consistently apply that rule for all foreign corporations.

IV. Remaining Issues and Outlook

Although Treasury and the IRS have provided some helpful relief, issues remain. For example, the preamble to the final regulations highlights a few other issues that are not addressed. Treasury and the IRS determined that there is no statutory or regulatory authority to modify the limitation on the portfolio interest exemption for payments received by CFCs from a related person. Also, Treasury and the IRS determined that the application of section 1248(a) to CFCs that were created by section 958(b)(4) repeal is consistent with the application of section 958(b) for purposes of the subpart F rules. And, as mentioned earlier, the fundamental issue of the creation of new U.S. shareholders, new CFCs, and new subpart F income and GILTI inclusions has not been addressed.

Given that Treasury and the IRS appear to have determined that they lack the authority to address other collateral consequences caused by the repeal of section 958(b)(4), these issues likely will not be ameliorated without congressional action. There have been legislative proposals to restore section 958(b)(4) while addressing the decontrolling transactions that motivated its repeal. For example, in March 2020 a version of the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136) would have restored section 958(b)(4) to its pre-TCJA wording while enacting a new section 951B. Similar proposals are likely to emerge in future legislation.

Proposed section 951B (titled “Amounts Included in Gross Income of Foreign Controlled United States Shareholders”) would create the new categories of foreign-controlled U.S. shareholder and foreign CFC and extend the application of the subpart F income, GILTI, and section 965 regimes to foreign-controlled U.S. shareholders of foreign CFCs. For this purpose, a foreign-controlled U.S. shareholder means any U.S. person that would be a U.S. shareholder of a particular foreign corporation if restored section 958(b)(4) were not applied (that is, no limitation on downward attribution exists) and if the section 951(b) definition of U.S. shareholder with a threshold of more than 50 percent, rather than a threshold of more than 10 percent, were applied. A foreign CFC means any non-CFC that would be a CFC if section 957(a) were applied by considering foreign-controlled U.S. shareholders instead of U.S. shareholders and by applying section 958(b) without reference to restored section 958(b)(4).

After the TCJA was enacted, it seemed at times that the unintended ramifications of the repeal of section 958(b)(4) would almost certainly be fixed — by Congress or by Treasury and the IRS — because the collateral damage was so significant. Three years later, a few other errors in the TCJA have been corrected, such as the “retail glitch” (the failure to assign qualified improvement property a 15-year recovery period and thus allow it to be eligible for bonus depreciation) and the “grain glitch” (which allowed higher tax deductions in many cases to patrons who sold commodities to cooperatives rather than to noncooperatives). However, the “attribution glitch” remains, and despite efforts by Treasury and the IRS to limit unintended ramifications, without action by Congress, it will continue to have significant consequences for taxpayers of many types and across industries.

Table of Contents: Repeal of the Limitation on Downward Attribution, Form 5471 and Safe Harbors from Rev Proc 2019-40

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