IRS Issues Proposed Regulations to Curb Section 951(a)(2)(B) Tax Planning
Introduction: Consolidated Groups and Section 951(a)(2)(B) Tax Planning
On December 9, 2022, Treasury and the IRS released proposed regulations that are intended to stop certain U.S. shareholder tax planning under section 951(a)(2)(B). Proposed Regulation § 1.1502-80(j) modify the consolidated return regulations to treat members of a consolidated group as a single U.S. shareholder in certain cases for purposes of applying section 951(a)(2)(B). The preamble to the proposed regulations states that Treasury and the IRS are aware that some consolidated groups were engaging in tax planning that reduced the consolidated group’s aggregate pro rata share of a lower-tier CFC’s subpart F income or tested income under section 951(a)(2)(B). Additionally, in the proposed regulations, the government once again warned taxpayers that it may assert other authorities or common law doctrines such as economic substance to challenge or recast the tax treatment of a transaction. This is consistent with recent government messaging that it may begin to assert economic substance more frequently than it has in the past. Below, we discuss the section 951(a)(2)(B) tax planning at issue and the mechanics of Proposed Regulation § 1.1502-80(j)(1) and (2).
Subpart F, Tested Income, and Previously Taxed Earnings and Profits
Under sections 951(a)(1)(A) and 951A(a) a U.S. shareholder of a CFC is subject to tax on certain income of the CFC, regardless of whether the CFC has distributed the E&P attributable to such income. To avoid double taxation, under section 959, a portion of the CFC’s E&P is designated as previously taxed earnings and profits (“PTEP”) and generally is not subject to U.S. tax when it is distributed to the U.S. shareholder (a section 959(a) distribution) or to an upper-tier CFC (a section 959(b) distribution). PTEP is treated as distributed before E&P that is not PTEP and a section 959(a) distribution is not treated as a dividend. As a result of the Tax Cuts and Jobs Act, much of a CFC’s income has been or will be subject to tax because of the section 965 transition tax and the new GILTI regime. Accordingly, there is a substantial amount of PTEP in the U.S. tax system that may be used by taxpayers in conjunction with certain tax planning.
Section 951(a)(1)(A) provides that a U.S. shareholder of a CFC must include in gross income its pro rata share of the CFC’s subpart F income if the U.S. shareholder owns (under section 958(a)) stock of the CFC on the last day of the CFC’s tax year on which it is a CFC (the last relevant day). A U.S. shareholder’s pro rata share of the CFC’s subpart F income is calculated under section 951(a)(1)(A) based on the U.S. shareholder’s proportionate share of a hypothetical distribution by the CFC, (unreduced by distributions during the year) allocable to stock of the CFC that the U.S. shareholder owns on the last relevant day. However, the amount under section 951(a)(1)(A) is reduced by the amount described in section 951(a)(2)(B) to reach the U.S. shareholder’s pro rata share of subpart F income.
A U.S. shareholder’s GILTI inclusion amount is the U.S. shareholder’s pro rata share of tested items (see Treas. Reg. § 1.951A-1(f)(5)) of certain CFCs in which the U.S. shareholder owns stock. A U.S. shareholder’s pro rata share of a CFC’s tested items is determined in the same manner described above that is applicable to a U.S. shareholder’s pro rata share of subpart F income under section 951(a)(2), subject to certain modifications.
Section 951(a)(2)(B)
As discussed above, a U.S. shareholder’s section 951(a)(1)(A) amount is reduced by its section 951(a)(2)(B) amount. Generally, section 951(a)(2)(B) provides that if stock of a CFC owned by a U.S. shareholder on the last relevant day of the year was acquired by the U.S. shareholder during the CFC’s taxable year, the U.S. shareholder’s pro rata share of subpart F income or tested income is reduced by the amount of distributions received by any other person during the taxable year as a dividend with respect to the acquired stock. The reduction is limited to an amount of the dividend that would have been received if the CFC had distributed an amount equal to its subpart F income multiplied by the number of days during the tax year on which the U.S. shareholder did not own the acquired stock over the number of days during the tax year.
This reduction represents an amount of distributed income on which the U.S. shareholder otherwise would have been subject to U.S. tax by reason of owning the stock on the last relevant day but such income is not allocable to the U.S. shareholder’s holding period in the acquired stock. The policy underlying this provision was to prevent double taxation of CFC income that is distributed during the tax year. The limitation ensures that income allocable to the U.S. shareholder’s holding period is included in the U.S. shareholder’s pro rata share.
Consolidated Group Rules Applicable to U.S. Shareholder Members
In a consolidated group, a member’s inclusion under section 951(a)(1)(A) is determined at the member level. In contrast, a consolidated group member’s GILTI inclusion is determined by taking the aggregate of its pro rata share of tested income of each tested income CFC and its allocable share of the consolidated group’s aggregate amount of other tested items. In T.D. 9866, Treasury and the IRS explained that this approach for a consolidated group member’s GILTI inclusion creates consistent results regardless of which member owns the stock of the CFCs, and removes incentives for tax planning.
Section 951(a)(2)(B) Tax Planning
Some consolidated groups were engaging in tax planning to reduce a U.S. shareholder’s pro rata share of subpart F income and tested income through section 951(a)(2)(B). Generally, taxpayers would make a section 959(b) distribution by a lower-tier CFC to an upper-tier CFC, together with a direct or indirect acquisition of the lower-tier CFC stock by another consolidated group member (for example, in a section 368(a)(1)(B) reorganization). As a result of this transaction consolidated groups took the position that the aggregate pro rata share of the lower-tier CFC’s subpart F or tested income is reduced under section 951(a)(2)(B) by reason of the prior section 959(b) distribution made by the lower-tier CFC earlier in the CFC’s tax year. This is because, under section 951(a)(2)(B) a U.S. shareholder’s pro rata share is reduced by the amount of distributions received by any other person during the taxable year as a dividend, multiplied by the ownership fraction described above. Because the section 959(b) distribution occurred prior to the acquiring U.S. shareholder’s holding period, consolidated groups took the position that the acquiring U.S. shareholder’s pro rata share was reduced by that distribution, limited by the holding period fraction.
This position was possible because the rules provided that a group member’s section 951(a)(1)(A) inclusion occurred at the member level, rather than at the consolidated group level, and because section 951(a)(2)(B) expressly permitted a reduction as a result of a distribution received by any other person. Accordingly, by making a section 959(b) distribution during the initial U.S. shareholder’s holding period, and then transferring the stock of the CFC that made the distribution to a second U.S. shareholder that was part of the same consolidated group, the consolidated group could significantly reduce income inclusions under sections 951(a)(1)(A) and 951A(a).
Treasury and the IRS’s Concerns on Section 951(a)(2)(B) Tax Planning
Treasury and the IRS explained that this position does not clearly reflect the consolidated group’s U.S. tax liability and that the group’s aggregate income inclusions should not be affected when ownership of the CFC stock moves within the group. They also noted that the position is inconsistent with the purposes of section 951(a)(2)(B). The amount in section 951(a)(2)(B) is supposed to represent a CFC’s distributed income on which a U.S. shareholder would be subject to tax by reason of owning stock of the CFC on the last relevant day. E&P that was already taxed, like section 959(b) PTEP cannot represent such income. The impact of the position is amplified when paired with the section 245A dividends received deduction. Any untaxed income as a result of this position could be eligible for the section 245A DRD when the E&P corresponding with the untaxed income is distributed to a U.S. shareholder. This could result in a permanent reduction to U.S. tax.
Mechanics of Proposed Regulation § 1.1502-80(j)
To address what Treasury and the IRS view as inappropriate outcomes under the section 951(a)(2)(B) tax planning, the proposed regulations treat members of a consolidated group as a single U.S. shareholder. Specifically, members of a consolidated group are treated as a single U.S. shareholder for purposes of applying section 951(a)(2)(B) in the context of section 959(b) distributions. The result of this rule is that direct or indirect acquisitions of CFC stock by one member from another member of a consolidated group do not result to a section 951(a)(2)(B) reduction. This is because the numerator of the holding period fraction includes both group members’ holding periods of the CFC stock. Proposed Regulation § 1.1502-80(j)(2) provides two examples that illustrate the application of the rules. The government believes that this outcome more clearly reflects the U.S. tax liability of a consolidated group. The rules in Proposed Regulation § 1.1502-80(j)(1) and (2) apply to taxable years for which the original consolidated return is due (without extensions) after the publication date in the Federal Register of a Treasury Decision adopting the rules as final regulations.
Other Considerations Raised by Proposed Regulation § 1.1502-80(j)
The government notes that Proposed Regulation § 1.1502-80(j)(1) and (2) do not apply to dividends of non-PTEP as other rules may result in the dividend being included in the gross income of a U.S. shareholder. Additionally, the preamble to the proposed regulations state that Treasury and the IRS are further considering the interaction of sections 951(a)(2)(B) and 959(b). This suggests that there is additional tax planning that they are considering. Perhaps this is a nod to the forthcoming PTEP guidance and that any additional concerns relating to these provisions will be addressed through that guidance.
Warning on Economic Substance
Finally, the government included a warning to taxpayers that it may look to “other authorities or common law doctrines” to recast a transaction or otherwise affect the tax treatment of a transaction and cited sections 482 (transfer pricing) and 7701(o) (economic substance). This is consistent with a recent trend of public statements by government officials. During a recent ABA panel, an IRS official suggested that the government is going to raise economic substance arguments more frequently than it has done in the past to challenge transactions or results of transactions that it views as inappropriate. It appears that in the future the government is going to take a much broader approach in applying economic substance principles to challenge certain tax planning that is not addressed by regulations or notices. The prospect that economic substance may be used in a broader manner than in the past is likely to give pause both taxpayers and their advisors when planning and executing transactions that may be challenged.
Conclusion
These proposed regulations come on the heels of the government’s withdrawal of the 2006 proposed PTEP regulations and are the government’s latest attempt to curb what it views as inappropriate tax planning. For a discussion of the government’s withdrawal of the 2006 proposed PTEP regulations and the transactions the government was targeting see our prior blog post, Withdrawal of 2006 Proposed PTEP Regulations, here. It is clear that the government is focused on cross-border tax planning and will use every tool available including, economic substance, to curb transactions that it views as producing inappropriate results or contrary to policy.
Expert Tax Attorneys
If you have a question about the proposed regulations, need assistance reporting a transaction or managing your Tax Compliance process, Freeman Law can help clients navigate these complex reporting obligations as well as Tax Planning. We offer value-driven services and provide practical solutions to complex tax issues. Schedule a consultation or call (214) 984-3000 to discuss your tax concerns.
