by Amanda Varma & Brigid Kelly
On November 2, the US Treasury Department and IRS issued final regulations (T.D. 9792) addressing various issues arising under subpart F, which is designed to prevent the deferral of passive or mobile income through the use of controlled foreign corporations (CFCs).
Final regulations under section 956 include provisions relating to the treatment of obligations of foreign partnerships, property held by a CFC through partnerships, and the application of an anti-avoidance rule. The final regulations adopt, with some changes, proposed regulations issued in September 2015. Treasury and the IRS also issued proposed regulations (REG-114734-16) under section 956 addressing special allocations made with respect to property treated as held by a CFC through a partnership.
Final regulations under section 954 address whether a CFC is considered to derive rents and royalties in the active conduct of a trade or business. These regulations replace identical temporary regulations issued in September 2015.
This article provides an overview of the key provisions set forth in the final and proposed regulations.
Background
A US shareholder of a CFC is generally required to include in income its pro rata share of the CFC’s subpart F income, which includes, among other amounts, passive income such as certain rents and royalties not derived in an active trade or business.
In addition, under rules targeting deemed repatriation, a US shareholder also must include in income an amount based in part on the US shareholder’s share of “United States property” held by a CFC.
Section 956 regulations on partnerships and anti-avoidance rule
The 2016 final regulations under section 956 generally retain the basic approach and structure of the 2015 proposed regulations, with certain revisions. The key provisions and features of the 2016 final and proposed regulations include the following:
— Anti-avoidance rule. Similar to the 2015 temporary regulations, the 2016 final regulations provide that the anti-avoidance rule relating to the amount of United States property treated as being held indirectly by a CFC can apply when a foreign corporation controlled by a CFC is funded by any means (including through capital contributions or debt) and to transactions involving partnerships that are controlled by a CFC where there is “a principal purpose” of avoiding the application of section 956. In response to comments, Treasury and the IRS added several new examples illustrating certain common business transactions in which the anti-avoidance rule does not apply.
In addition, the 2016 final regulations expand a coordination rule to avoid a CFC being treated as holding duplicative amounts of United States property under the anti-avoidance rule and the partnership rules (see below). These rules apply to tax years of CFCs ending on or after September 1, 2015, and to tax years of US shareholders in which or with which such tax years end, for property acquired on or after September 1, 2015.
— Partnership property held indirectly by a CFC partner. Like the 2015 proposed regulations, the final regulations treat a CFC partner as holding its attributable share of the partnership’s property. The partner’s adjusted basis in partnership property equals the partner’s attributable share of the partnership’s adjusted basis in the property (i.e., the partnership’s inside basis), determined in accordance with the CFC partner’s liquidation value percentage (determined by reference to the amount of cash a partner would receive if the partnership sold all of its assets for cash equal to the fair market value of such assets, paid an unrelated third party to assume certain liabilities, satisfied all of its other liabilities, and then liquidated).
The 2016 final regulations obsolete the holding in Revenue Ruling 90-112, which provided that the amount of United States property taken into account for purposes of section 956 when a CFC partner indirectly owned property through a partnership was limited by the CFC’s adjusted basis in the partnership (i.e., the CFC’s outside basis). The indirect property rules apply to tax years of CFCs ending on or after November 3, 2016, and to tax years of U.S. shareholders in which or with which such tax years end, for property acquired on or after November 3, 2016.
— Aggregate approach for treating an obligation of a foreign partnership as an obligation of its partners. The 2016 final regulations retain the general aggregate approach of the 2015 proposed regulations with respect to obligations of foreign partnerships (i.e., an obligation of a foreign partnership is treated as an obligation of its partners, subject to an exception for unrelated partners). As a result, a CFC loan to a foreign partnership may be treated as United States property where the partnership has a US shareholder. However, unlike the proposed regulations, which determined a partner’s share of a partnership obligation in accordance with partnership profits, the 2016 final regulations determine a partner’s share in accordance with the partner’s liquidation value percentage.
In the preamble, Treasury and the IRS reject the notion that the aggregate approach is not supported by the policy of section 956, arguing instead that “failing to treat an obligation of a foreign partnership as an obligation of its partners could allow for the deferral of US taxation of CFC earnings and profits in a manner that is inconsistent with the purpose of section 956” because deferred CFC earnings have been made available to a US shareholder where the shareholder conducts operations through a foreign partnership funded by the CFC. The obligation rules apply to tax years of CFCs ending on or after November 3, 2016, and to tax years of U.S. shareholders in which or with which such tax years end, for obligations acquired on or after September 1, 2015.
— Application of liquidation value percentage method. As stated above, the 2016 final regulations use the liquidation value percentage to determine both a CFC partner’s attributable share of partnership property and a partner’s share of a foreign partnership obligation. The liquidation value percentage must be redetermined when a “revaluation event” under the section 704 regulations occurs, as well as certain additional circumstances (such as if the liquidation value percentage determined for a partner on the first day of the partnership’s tax year would differ by more than 10 percentage points from the most recently determined liquidation value percentage for that partner).
Rules regarding special allocations apply for determining a CFC partner’s attributable share of partnership property. If a partnership agreement provides for a special allocation of book income or gain from a subset of partnership property, than the partner’s attributable share of that property is determined solely by reference to the partner’s special allocation, unless the special allocation has a principal purpose of avoiding the purposes of section 956.
Proposed regulations issued concurrently with the final regulations, however, would provide that a CFC that is a partner in a controlled partnership (within the meaning of section 267(b) or section 707(b), substituting “at least 80 percent” for “more than 50 percent”) determines its share of United States property held by the partnership under the liquidation value percentage method, regardless of the existence of any special allocation.
According to the preamble to the 2016 proposed regulations, Treasury and the IRS are concerned that “special allocations with respect to a partnership that is controlled by a single multinational group are unlikely to have economic significance for the group as a whole and can facilitate tax planning that is inconsistent with the purposes of section 956.”
— Treasury, IRS “continue to study” multiple inclusions under section 956(d). The preamble acknowledges that Treasury and the IRS continue to consider guidance concerning situations in which multiple CFCs serve, or are treated, as pledgors or guarantors of a single obligation. Current law raises the possibility of multiple inclusions in such situations.
— Other rules. The 2016 final regulations also take into account certain statutory changes in the Revenue Reconciliation Act of 1993 (P.L. 103-66) regarding the methodology for calculating the amount determined under section 956 with respect to a US shareholder of a CFC (Treas. Reg. § 1.956-1) and adopt regulations proposed in 1988 and 2015 regarding the application of section 956 to property acquired by a CFC in certain related party factoring transactions.
Active rents and royalties
The 2016 final regulations also finalize, with no changes, 2015 temporary regulations addressing the active rents and royalties exception that excludes from subpart F rents and royalties received in connection with property that the CFC has actively developed or actively marketed.
The regulations expressly provide that a CFC lessor or licensor must perform certain functions through its own officers or staff of employees to satisfy the active development test, permit marketing functions to be carried out in more than one foreign country for purposes of the active marketing test, and provide that cost-sharing transaction payments and platform contribution transaction payments made by a CFC will not cause the CFC officers and employees to be treated as undertaking the activities of the controlled participant to which the payments are made.
The rules apply to rents or royalties received or accrued during taxable years ending on or after September 1, 2015, with respect to property manufactured or rents or royalties received on or after September 1, 2015.
Amanda Varma
Amanda Varma advises clients on US federal income tax matters, with particular focus on international tax planning and controversies.
Her practice includes counseling domestic and foreign businesses with respect to cross-border acquisitions, business restructurings, and financings, tax treaty matters, deferral and foreign tax credit issues, transfer pricing, and withholding and reporting issues.
She also regularly advises clients on special issues arising in international tax controversies, including competent authority and information exchange. Ms. Varma also represents clients in connection with regulatory and legislative tax policy matters.
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Brigid Kelly
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