The IRS has issued a set of final regulations and related proposed regulations covering a number of issues involving the Sec. 245A deduction for dividends received from 10% owned foreign corporations (DRD), the exception to subpart F income for some dividend received from controlled foreign corporations (CFCs), and coordination of the DRD with the global intangible low-taxed income (GILTI) tax regime. The new rules also impose reporting requirements on corporations and partnerships designed to facilitate administration of the final regulations.
TCJA Changes
Section 245A was enacted by the Tax Cuts and Jobs Act (TCJA) as part of the shift to a modified territorial tax system in the U.S. It allows a 100% dividends received deduction to domestic corporations for dividends received from foreign corporations after December 31, 2017. The Act also provides an exception to subpart F income for certain dividends received by controlled foreign corporations (CFCs). As part of the transition to the territorial system, E&P generated before the applicability of the DRD and not previously subject to U.S. tax is subject to a transition tax under Section 965. The final regulations address the interplay of these provisions.
New Rules Seek to Close Gaps
The IRS explains that the new regulations are intended to close gaps that could result in some income not being taxed because it falls through both the old and new rules. Two key limitations in the final rules are:
- Extraordinary dispositions. The new rules reduce the DRD for 50% of any “extraordinary disposition” amount. This rule applies to U.S. shareholders of foreign corporations that are eligible for the DRD on distributions from the foreign corporation, and the foreign corporation uses a fiscal year, as opposed to the calendar year, as its taxable year. An extraordinary disposition can occur when a foreign corporation engaged in a sale of property to a related party: (1) during the period between January 1, 2018, and the end of the foreign corporation’s last taxable year beginning before January 1, 2018; (2) outside the ordinary course of the foreign corporation’s activities; and (3) while the corporation was a CFC. The property sold must be of a type that would give rise to tested income, and the value of the property sold must exceed the lesser of $50 million or 5% of the total value of all of the foreign corporation’s property.
- Extraordinary reductions. The DRD also is reduced in the case of an “extraordinary reduction”, which occurs when a controlling Section 245A shareholder disposes of more than 10% of its CFC stock or there is a greater than 10% change in the controlling shareholder’s ownership in the CFC. The IRS explains that this rule is necessary because allowing the full DRD can result in complete avoidance of U.S. tax with respect to subpart F income or tested income that, absent the extraordinary reduction, would have been included in income by the selling U.S. shareholder under the subpart F or GILTI regimes.
Proposed Regulations Offer GILTI Coordination
The proposed regulations adopt a coordination mechanism that prevents excess taxation in the case of an extraordinary disposition or the disqualified basis rule, contained in the GILTI final regulations. Under this rule, a deduction or loss attributable to basis created by reason of a transfer of property from a CFC to a related person during the disqualified period (“disqualified basis”) is allocated and apportioned solely to residual CFC gross income. The coordination mechanism involves two operative rules, one that reduces disqualified basis in certain cases and another that reduces an extraordinary disposition account in certain cases.
There are many more details in the proposed regulations including multi-page examples showing different scenarios.
The final regulations became effective August 27, 2020. The IRS is seeking comments on the proposed regulations before finalizing them. Consult a Frazier & Deeter international tax expert to determine what effect the new regulations could have on your foreign investments. For questions regarding foreign DRDs, contact David Patton, Tax Senior Manager.