Final Section 245A Regulations Deny the Dividends Received Deduction in Certain Transactions
By Lazar Aguilera with Ivins, Phillips & Barker, Chtd.
September 4, 2020
Effective August 27, the Treasury and IRS have finalized (T.D. 9909) temporary and proposed regulations, originally issued last year under section 245A, that treat as taxable dividends (not eligible for the section 245A dividends received deduction) amounts paid from earnings and profits (“E&P”) generated from specified transactions that the government views as abusive. The final regulations largely adopt the rules proposed in 2019, with limited revisions to reflect taxpayer comments. Newly issued proposed regulations address certain circumstances in which taxpayers may have been subject to double taxation as a result of the 2019 temporary regulations and an anti-abuse rule in the section 951A regulations (the “disqualified basis rule”).
Temporary Regulations and Final Rules
Under the temporary and proposed regulations issued in 2019 (T.D. 9865, now withdrawn), E&P generated in two different types of transactions is ‘tainted’ E&P that when distributed is not eligible for the section 245A deduction. The first type of transaction is one that occurred during a transition period following the enactment of the Tax Cuts & Jobs Act. Under a (possibly unintended) mismatch in effective dates, non-calendar year controlled foreign companies (“CFCs”), could have generated E&P not subject to taxation as GILTI under section 951A but that would be eligible for the section 245A deduction when paid as a dividend. The second type of transaction is one in which there is a transfer of CFC stock in which E&P, that otherwise would have been taxable as subpart F or GILTI to the selling shareholder, is not taxable to the acquirer.
The temporary regulations limit a shareholder’s otherwise allowable section 245A deduction to 50% of the “extraordinary disposition amount.” That is equal to the portion of a dividend paid out of the company’s “extraordinary disposition account,” which, under the regulations, taxpayers are required, to maintain and which tracks amounts generated from gain recognized in “extraordinary dispositions.”
A disposition of property is generally considered an extraordinary disposition if it occurs during the disqualified period (for non-calendar year taxpayers, between January 1, 2018, and the beginning of the CFC’s 2018 taxable year), outside of the ordinary course of activities, and to a related party. An exception to the general rule applies in the case of dispositions that are not more than $50 million and 5% of the gross value of the entity’s property.
The second type of disallowed section 245A deduction occurs when there is an “extraordinary reduction” transaction, resulting in an “extraordinary reduction amount.” An extraordinary reduction transaction occurs when either the controlling U.S. shareholder transfers more than 10% of its stock in the CFC or there is a greater than 10% change in the controlling shareholder’s overall ownership of the CFC.
The extraordinary reduction amount is the E&P equal to the dividends paid attributable to subpart F income or tested income, to the extent such amounts would have been taken into account by the controlling U.S. shareholder under either section 951 or section 951A had the extraordinary reduction not occurred, and are not taken into account by a U.S. person.
As with the extraordinary disposition transaction, there is an exception for transactions where the sum of the CFC’s subpart F income and tested income is not more than $50 million and 5% of the CFC’s total income for the year. Taxpayers can elect a closing of the books option, in which the CFC’s books are deemed to close as of the date of the transaction as a result of which it will be considered to not have made an extraordinary reduction.
As a backstop to these rules, there are additional rules that would turn off the look-through exception to subpart F in section 954(c)(6) in the case of tiered extraordinary distributions or tiered extraordinary reductions, from one CFC to another.
There has been speculation that due to strongly-worded comments questioning Treasury’s authority on these regulations, they may have been scaled back when issued in final form. This is not the case and taxpayers who have undertaken transactions subject to these regulations, and are taking a position contrary to the rules, need to disclose that position on Form 8275-R.
Revised Final Regulations
The Treasury and IRS received many comments questioning their authority to issue the temporary regulations, which retroactively turned off the statute’s effective date.
Comments also requested relief from various aspects of the proposed and temporary regulations. The final regulations mostly reject those comments, but do revise the temporary regulations in some respects.
For example, the final regulations include a new exception for certain transfers of intangible property, which are not considered an extraordinary disposition provided that the intangible property is transferred to a related party with a reasonable expectation that it would be sold to an unrelated customer within a year of the transfer. The final regulations modify the definition of a prior extraordinary disposition amount to take into account certain income inclusions under section 956. They also provide additional rules governing the transfer of extraordinary disposition accounts in nonrecognition and standalone section 355 transactions, as well as section 338(g) transactions.
The final regulations clarify that in the case of taxpayers wishing to elect a deemed closing of the CFC’s books, generally each controlling section 245A shareholder and each U.S. tax resident that is a United States shareholder of the CFC at the end of the day of the extraordinary reduction must enter into a binding agreement to close the taxable year of the CFC.
Because of the rule requiring that all shareholders participate in the election to close the CFC’s tax year, this will need to be negotiated and addressed in acquisition agreements.
New Proposed Regulations
New proposed regulations issued together with the final section 245A regulations provide relief for taxpayers in that they better coordinate the extraordinary disposition rules (in Reg. § 1.245A-5) with the rules in Reg. § 1.951A-2 applicable to disqualified basis transactions.
Without the coordination rule, E&P generated by CFCs already subject to full taxation under Reg. § 1.245A could be subject to double taxation if the rule in Reg. § 1.951A-2(c), which requires taxpayers to reduce the basis of certain disqualified property to prevent inappropriate reductions to taxpayers’ tested income, also applies to the same transaction. Under that rule, a deduction or loss attributable to basis created by reason of a transfer of property from a CFC to a related person during a disqualified period (“disqualified basis”) is allocated and apportioned solely to residual CFC gross income, defined as income other than subpart F, section 951A tested income, or income effectively connected with a U.S. trade or business. The disqualified period is the period for a fiscal year CFC beginning on January 1, 2018 through the start of its first taxable year in 2018.
Under the proposed regulations, transactions that could be subject both to the extraordinary disposition rule of Reg. § 1.245A-5 and the disqualified basis rule of Reg. § 1.951A-2(c) are subject to one of two coordinating rules: a rule that reduces the disqualified basis (“DQB”) amount – the DQB reduction rule, or a rule that reduces the extraordinary disposition account (the “EDA reduction rule”). Each of these rules has two variations: one that applies to “simple” cases and one that applies to more complex ones. Under the “simple” DQB reduction rule, when an extraordinary disposition account gives rise to an extraordinary disposition amount, the disqualified bases of specified property are correspondingly reduced, solely for purposes of the disqualified basis rules. The “simple” EDA reduction rule applies to reduce the extraordinary disposition account when items of deduction or loss attributable to the disqualified basis are allocated and apportioned to residual CFC gross income and reduce E&P that could otherwise potentially qualify for the section 245A deduction when distributed.
The proposed regulations also contain an anti-avoidance rule, under which appropriate adjustments are made if a transaction or arrangement is engaged in with a principal purpose of avoiding these proposed regulations. For example, the anti-avoidance rule applies if a shareholder causes its taxable year to end on a particular date with a principal purpose of avoiding a basis benefit amount from being assigned to that taxable year.
The proposed regulations are generally beneficial to taxpayers in that they limit the potential for double taxation arising from transactions that may be subject to the rules under both 1.245A-5 and the rules requiring adjustments for disqualified basis under 1.951A-2(c). But because of the rule requiring that taxpayers apply the proposed regulations consistently, they may or may not wish to apply them on a retroactive basis.
For the most part, the final section 245A regulations apply to distributions made after the statute’s effective date. In a case where either the temporary regulations or the final regulations could apply, generally only the final regulations apply. A taxpayer may choose to apply the final regulations to distributions made during the period in which the temporary regulations and the final regulations are concurrent, provided that all related parties consistently apply the final regulations in their entirety. The newly issued proposed regulations apply to tax years of foreign corporations beginning the date the rules are finalized. Taxpayers can choose to apply the proposed regulations before that date, provided that they (and all related parties) consistently apply the rules to those taxable years.
Please contact your Mazars USA LLP professional for additional information.
This alert was produced in conjunction with Ivins, Phillips & Barker, Chtd.