"Ay, sir, there's no more trick is there! You are not, like Cerberus, three gentlemen at once, are you?"

–Mrs. Malaprop to Captain Absolute in Richard Brinsley Sheridan's The Rivals (1775), Act IV, scene 2

A participation exemption is a feature of many territorial systems and eliminates incremental tax on foreign-source income. Under the Tax Cuts and Jobs Act of 2017, Pub. L. No. 115-97, ("T.C.J.A."), the U.S. tax law acquired a 100% dividends received deduction ("D.R.D.") for foreign-source dividends received by domestic U.S. corporations from 10%-owned foreign subsidiaries arising in tax years beginning after December 31, 2017.1

The new D.R.D. applies to a certain limited class of taxable distributions by a C.F.C. to its U.S. corporate parent. It also applies to certain other distributions by a foreign corporation to a U.S. corporation owning a 10% or greater interest, where (i) all such 10% U.S. shareholders in the aggregate own shares representing not more than 50% of the value or voting power of the foreign corporation and (ii) the foreign corporation is are not considered to be a P.F.I.C. The new D.R.D. extends to capital gain on certain dispositions of foreign corporation stock, provided that the gain is attributable to retained earnings and for that reason is converted to dividend income under Code §1248.2

As background, the U.S. imposes tax on the worldwide income of its citizens and U.S.-incorporated companies. This feature was retained after the T.C.J.A. and has always been coupled with (i) deferral of foreign earnings earned through corporate form and (ii) provisions eliminating deferral under the C.F.C. rules of Subpart F. Confusingly, these elements are retained, the global low tax intangible income rules of Code §951A have been added, and the participation exemption has been grafted on top of the whole lot. Prior to the T.C.J.A., former Code §902 provided that when a domestic corporation received a dividend from a foreign corporation in which it owned at least 10% of the voting shares, the domestic corporation was deemed to pay a proportional share of the foreign corporation's foreign taxes. The gross taxable dividend to the U.S. corporation equaled the sum of the dividend declared and the accompanying taxes that were "grossed-up" into the dividend.3 The T.C.J.A. repealed Code §902 and now provides the D.R.D. instead when the U.S. corporation is not taxed under Subpart F and G.I.L.T.I. rules. In such case, the indirect foreign tax credit remains in existence.4

Enter 105 pages of temporary regulations, issued on June 14, 2019 under Temp. Reg. §1.245-5T ("Temporary Regulations"), adopted in T.D. 9865, which provides rules to address certain base erosion concerns identified by the I.R.S., in the context of Code §245A's purpose in the broader tax system.5

The Temporary Regulations seem to serve a role like that of Cerberus,6 the multi-headed canine who watched over the gates of Hades in Greek mythology. They address very specific concerns relating to erosion of Subpart F and G.I.L.T.I. This article reviews the D.R.D provisions, including the Temporary Regulations, so that their Cerberus-like complexity can be understood — transforming the task from a labor worthy of Herakles to a walk in the park.

MAIN FEATURES OF CODE §245A

The Code §245A D.R.D. applies where a U.S. domestic corporation (the "Code §245A shareholder") owns at least 10% of a foreign corporation, by vote or value – with the foreign corporation referred to as a "specified 10-percent owned foreign corporation" ("S.F.C.") – from which a dividend is received.

The ownership of the distributing's stock must be effective for a one-year holding period. The D.R.D. applies only to the foreign-source portion of a dividend received.

The foreign-source portion of a distribution is determined by multiplying the amount of the distribution described in Code §301(c)(1) (a dividend out of earnings and profits ("E&P")) by a fraction, the numerator of which is the S.F.C.'s undistributed foreign earnings, and the denominator of which is the S.F.C.'s total undistributed earnings. Congress defined "undistributed foreign earnings" as undistributed earnings that are neither effectively connected income ("E.C.I.") nor dividends received from a U.S. domestic corporation in which at least 80% is owned, directly or indirectly, by the S.F.C. The term "undistributed earnings" means total earnings at the close of the year, excluding previously-taxed earnings under Code §959(c)(1) and (c)(2) ("P.T.I.").7 In broad terms, P.T.I. means the earnings that have been taxed in the hands of the U.S. corporate shareholder under the Subpart F or G.I.L.T.I. provisions of U.S. tax law. Meanwhile, the U.S.-source portion potentially may separately also be eligible for a D.R.D. under the pre-T.C.J.A. D.R.D. provided for in Code §245(a), which has been part of the tax law for many years.8

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Footnotes

1. Separately, see the fourth article in this edition of Insights by Neha Rastogi and Nina Krauthamer, titled " Heads I Win, Tails You (I.R.S.) Lose – Not Any More: Hybrid Dividends and Code §245A(e)," addressing the hybrid provisions of Code §245A, including the relevant regulations issued this spring. A pre-existing D.R.D. under Code §245 further discussed in this article applied only to U.S.-source dividends, and not deemed dividends arising from the sale or exchange of C.F.C. stock.

2. This, through the back door of Code §1248. According to a 2017 blog posting, approximately 29 countries in the O.E.C.D. offer a participation exemption or deduction for dividend income, and 26 offer it for capital gains arising from the sale of shares of subsidiaries in which a minimum participation exists, with 25 countries offering both. See Kyle Pomerlau, "Designing a Territorial Tax System: A Review of OECD Systems" (Aug. 1, 2017), available here.

3. Code §78.

4. Code §960.

5. A proposed version of the same rules was issued at the same time in REG106282-18. Also proposed were a further 55 pages of final regulations under Code §§245A(e) and 267A, relating to hybrid dividends. Minor corrections were published at 84 Fed. Reg. 38866.

6. In Greek, "Kerberos," the offspring of the monsters Echidna and Typhon, the etymology of the name is uncertain but includes "Ker," a Valkyrie-like goddess of violent death.

7. Under Code §959(d), a distribution of previously taxed income does not constitute a dividend even if it reduces E&P, therefore Code §245A is inapplicable.

8. P.L. 83-591, Ch. 736. Code §245 refers to a "qualified 10-percent owned foreign corporation." See also Code §243(e), which extends a domestic D.R.D. to distributions received from a foreign subsidiary attributable to E&P accumulated by a domestic corporation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.