INTRODUCTION1

Imagine a straight line. Now assume that it represents a timeline – a timeline that divides the tax world into the pre and post T.C.J.A. era. You know the magic date, December 31, 2017.

Now imagine a pizza cut into three large slices. Assume that the pizza represents the earnings and profits of a Controlled Foreign Corporation ("C.F.C.") since inception. The C.F.C. is wholly owned by a U.S. corporation. It conducts an active business and also has income from passive investments. Using the pizza analogy, the U.S. Shareholder of the C.F.C. is subject to the following taxes on undistributed income, each representing one of the three slices of the pizza:

  • he Transition Tax2 on the accumulated untaxed earnings and profits of the C.F.C. prior to January 1, 2018 (Pie 1),
  • The Subpart F regime3 on the foreign earnings and profits post December 31, 2017, attributable to the passive income (Pie 2),4 and
  • The G.I.L.T.I. Tax5 on the earnings and profits attributable to the income generated from the active business income (Pie 3).

Each tax sucks up one of the three slices of the pizza. Holistically speaking, if a C.F.C. is subject to all three taxes, then, what is left on the table is an empty plate. In other words, after the T.C.J.A., it may be said that all or almost all of the earnings and profits of a C.F.C. are subject to U.S. tax even before they are actually distributed.

A subsequent distribution of the previously taxed income (P.T.I.) is received tax free in the hands of a U.S. Shareholder of the C.F.C.6 In this scenario, the question to be answered is whether Code §245A reflects an important tool for multinationals or, using the pizza analogy, is simply the leftover crumbs once other provisions adopted in the T.C.J.A. have been applied?

CODE §245A(a)

Code §245A, introduced by the T.C.J.A., offers a 100% dividends received deduction ("D.R.D.") for the foreign sourced dividends received by a U.S. corporation which owns at least 10% of the voting rights or value of the stock of a foreign corporation. By making the deduction applicable to a foreign corporation, it extends the benefit to dividends from a C.F.C. However, a careful tax adviser must ask whether any benefit is actually provided when earnings and profits are already subject to U.S. tax in one form or another (i.e., the Transition Tax, Subpart F, and the G.I.L.T.I. Tax) and a subsequent distribution of P.T.I. is received tax-free in the hands of a U.S. Shareholder under Code §959? The answer lies in the P.T.I. ordering rules under Code §959(c).

INTERACTION OF CODE §245A WITH CODE §959

Code §959(c) treats a distribution from a C.F.C. as first being attributable to earnings and profits not in excess of the investments in U.S. property, then attributable to Subpart F income (including the income subject to the G.I.L.T.I. Tax), and then attributable to taxable earnings and profits of the C.F.C. ("non-P.T.E.P."). The first two types of earnings and profits are excluded from U.S. tax when distributed7 and are not treated as a dividend, other than to reduce earnings and profits.8 In other words, distributions from a C.F.C. to its U.S. Shareholder out of P.T.E.P. are not eligible for the Code §245A(a) D.R.D. since they already are received tax-free. As a result, Code §245A does not apply to the distributions attributable to P.T.E.P.

However, Code §959(a) does not exclude from income a distribution that is made from non-P.T.E.P. The non-P.T.E.P. is treated as dividends to the extent provided under Code §316.9 In the absence of Code §245A(a), the distributions treated as dividends under Code §316 will be subject to U.S. Federal income tax in the hands of a U.S. Shareholder. However, Code §245A(a) provides that such dividends are no longer subject to U.S. tax in the hands of a domestic corporation that meets the definition of a U.S. Shareholder under Code §951(b). Therefore, the Code §245A D.R.D. in the context of a C.F.C. applies only when the distribution is made from non-P.T.E.P.

Example

F Co was organized under the laws of Country F on Jan 1, 2018. A U.S. corporation, US Co., is the sole shareholder of F Co. F Co is engaged in an active trade or business in Country F. It also has made investments in other companies that periodically generate dividend income. In addition to the stock, F Co. issued an instrument to US Co that is treated as debt under the laws of both countries. F Co paid interest of $20 on the debt to US Co. The interest is subject to withholding tax in Country F. US Co pays U.S. tax on the interest income of $20 after claiming a credit of the foreign taxes. At year end, F Co has active income of $400, dividend income of 100, and cash of $800.For 2018, US Co will have a Subpart F inclusion of $100. It will also be liable to pay the G.I.L.T.I. Tax on $400 representing the active trade or business income of F Co. Accordingly, P.T.E.P. of F Co amounts to $500.

In Year 2019, assume F Co., didn't earn any income but made a distribution of $700. Under the ordering rules of Code §959(c), the distribution will be treated as first coming from P.T.E.P. attributable to Subpart F and G.I.L.T.I. Therefore, US Co will receive the first $500 tax-free under Code §959(a). The balance of $200 is treated as dividend income under Code §316 (assuming there is sufficient earnings and profit). Since the recipient is a domestic corporation which meets the definition of a U.S. Shareholder, Code §245A(a) will apply and therefore, the dividend income of $200 will be received tax-free in the U.S.

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Footnotes

1. See also the sixth article in this edition of Insights by Andreas A. Apostolides and Stanley C. Ruchelman, titled " Anti-Abuse Rules of Temp. Reg. §1.245A-5T – A New Cerberus For the U.S. Tax System," addressing the general mechanics of Code §245A and the new D.R.D., including the Temporary Regulations with their anti-abuse focus.

2. The Transition Tax is a tax on the U.S. Shareholders of a C.F.C. on the untaxed foreign earnings as it stood on December 31, 2017 or November 3, 2017, if elected, as if those earnings had been repatriated to the U.S.

3. Generally speaking, Subpart F Income is the tainted income of a C.F.C. which is taxed to U.S. Shareholders on current basis regardless of any actual distributions by the C.F.C.

4. If you are lucky, you may be eligible to the few exceptions available in the Code, such as, the high foreign tax exception to Subpart F income.

5. Broadly speaking, the G.I.L.T.I. Tax is a tax imposed on U.S. Shareholders on their share of a C.F.C.'s income generated from activity outide the U.S. that is not otherwise taxed in the U.S. at the level of a U.S. Shareholder under Subpart F or to the C.F.C. as effectively connected income. The tax is imposed regardless of any actual distributions by the C.F.C.

6. Code §959 and §951A(f)(1).

7. Code §959(a).

8. Code §959(d).

9. Treas. Reg. §1.959-3(b).

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.