Section 245A: Tax Efficient Repatriation of a Foreign Subsidiary’s Earnings
Freeman Law frequently advises U.S. multinational corporations. United States-based international businesses are subject to complex reporting and compliance and anti-deferral regimes such as subpart F, global intangible low taxed income (“GILTI”), passive foreign investment company (“PFIC”), and the new corporate minimum tax that was enacted as part of the Inflation Reduction Act, Pub. L. 117-169 (2022). These regimes are enforcement mechanisms to ensure that foreign earnings are taxed on a current basis in the United States at a minimum corporate tax rate. As part of Tax Reform, the United States introduced a new dividends received deduction (“DRD”) in section 245A for the foreign-source portion of dividends received by certain domestic corporations (the “Section 245A DRD”). The “participation exemption” in section 245A is the cornerstone of the new quasi-territorial tax system. Section 245A can be a powerful taxpayer favorable provision to exempt dividends and deemed dividends received from certain foreign corporations if the statutory requirements are met. Since Tax Reform the IRS and Treasury Department issued several regulation packages that clarify and limit the scope of these rules. This post is an update to our prior post on the Section 245A DRD, and explains some of the tax planning opportunities where a domestic corporate taxpayer may be able to benefit from the Section 245A DRD.
Overview of the Section 245A DRD
The Tax Cuts and Jobs Act, Pub. L. 115-97 (2017) (the “TCJA”), enacted section 245A, which provides for a DRD for the foreign-source portion of dividends received by certain domestic corporations. As noted above, the headline international tax reform of the TCJA was the new participation exemption system in section 245A, which led to the United States transitioning from a worldwide tax system to a quasi-territorial tax system.[1]
Section 245A generally provides a 100-percent DRD that is equal to the foreign-source portion of dividends received from a “specified 10-percent owned foreign corporation” (“SFC”) by a domestic corporation that is a U.S. shareholder with respect to the distributing corporation. As defined in section 245A(b), an SFC is any foreign corporation with respect to which any domestic corporation is a U.S. shareholder, other than a passive foreign investment company (as defined in section 1297), that is also not a controlled foreign corporation (“CFC”) (as defined in section 957).[2]
The foreign-source portion of a dividend is the amount that bears the same ratio to the dividend as (1) the undistributed foreign earnings of the SFC bears to (2) the total undistributed earnings of the SFC.[3] Undistributed earnings are the E&P of a SFC (computed in accordance with sections 964(a) and 986) as of the close of the tax year of the SFC in which the dividend is distributed and without diminution by reason of dividends distributed during the tax year.[4] Undistributed foreign earnings are (1) undistributed earnings that are not effectively connected with the conduct of a trade or business within the United States (“ECI”), and subject to tax under Chapter 1 of the Code, or (2) are not dividends received from a domestic corporation that is at least 80-percent owned, directly or indirectly, by the qualified specified 10-percent owned foreign corporation.[5]
Exclusion for Hybrid Dividends
Under section 245A(e), the DRD is not available for “any dividend received by a United States shareholder from a controlled foreign corporation if the dividend is a hybrid dividend.” Section 245A(e)(4) defines a hybrid dividend as an amount received from a CFC (a) for which a deduction would have been allowed under section 245A(a) but for section 245A(e), and (b) for which the CFC received a deduction (or other tax benefit) with respect to any income taxes imposed by any foreign country. Additionally, under section 245A(e)(2), if a CFC with respect to which a domestic corporation is a U.S. shareholder receives a hybrid dividend from any other CFC to which the domestic corporation is also a U.S. shareholder then (a) the hybrid dividend shall be treated as subpart F income of the receiving CFC for the taxable year of the CFC in which the dividend was received and (b) the U.S. shareholder shall include in gross income an amount equal to the shareholder’s pro rata share of the subpart F income described in section 245(e)(2)(A). Section 245(e)(3) applies the rules of section 245A(d) in providing that no foreign tax credit or deduction is allowed for any hybrid dividend received by, or any amount included under section 245A(e)(2) in the gross income of, a U.S. shareholder. Treas. Reg. § 1.245A(e)-1(c)(2) provides that a tiered hybrid dividend is an amount received by a CFC from another CFC that would have been a hybrid dividend if the receiving CFC were a domestic corporation.
Treas. Reg. § 1.245A(e)-1(d)(1) requires each specified owner of a share of stock of a CFC to track which dividends may be treated as hybrid dividends by maintaining “hybrid deduction accounts” to reflect the amount of hybrid deductions of the CFC allocated to such share[6] with respect to each share of stock of a CFC. Hybrid deductions are defined as deductions or other tax benefits that (i) are allowed to the CFC (or a person related to the CFC) under relevant foreign tax law, and (ii) relate to or result from an amount paid, accrued, or distributed with respect to an instrument issued by the CFC and treated as stock for U.S. tax purposes but only if the deductions or other tax benefits have the effect of causing the earnings that funded the distribution to not be included in income or otherwise subject to tax in under the CFC’s foreign tax law.
Extraordinary Dispositions
The final regulations under section 245A also provide complicated and technical rules for certain transactions that result in a disposition of certain property or a reduction of the controlling section 245A shareholder’s interest in the CFC. These rules were essentially anti-abuse provisions to prevent the benefit of section 245A to certain transactions that resulted in stepped up basis or reduction of the controlling section 245A shareholder’s interest in a CFC.
The regulations disallow a deduction for 50 percent of the “extraordinary disposition amount”, which is equal to the portion of a dividend received by a section 245A shareholder from an SFC paid out of the section 245A shareholder’s extraordinary disposition account. An extraordinary disposition account is created with respect to an SFC when the SFC has engaged in an extraordinary disposition. Treas. Reg. § 1.245A-5(c)(3)(ii)(A) defines an “extraordinary disposition” as any disposition of specified property[7] by the SFC on a date on which it was a CFC and during the SFC’s disqualified period[8] to a related party if the disposition was outside of the ordinary course of the SFC’s activities. IRS and Treasury also promulgated a corollary rule that prevents an exception to foreign personal holding company income under section 954(c)(6) from applying where a dividend received from a lower-tier CFC to an upper-tier CFC would be an extraordinary disposition amount if distributed directly to the section 245A shareholders of the lower-tier CFC. The regulations provide that section 954(c)(6) does not apply to 50 percent of the sum of the section 245A shareholder’s tiered extraordinary disposition amount with respect to the lower-tier CFC.[9]
Extraordinary Reductions
Additionally, the regulations disallow the Section 245A DRD for the portion that represents an “extraordinary reduction amount.”[10] A controlling section 245A shareholder has an extraordinary reduction amount if: (1) it receives a dividend from a CFC during a taxable year of the CFC ending after December 31, 2017; and (2) an extraordinary reduction occurs with respect to the controlling section 245A shareholder’s ownership of the CFC.[11] An extraordinary reduction occurs when either: (1) during a taxable year, the controlling section 245A shareholder transfers, in the aggregate, more than 10 percent of the value of the stock of the CFC that the section 245A shareholder owns at the beginning of the CFC’s taxable year, or (2) one or more transactions reduce the percentage of the CFC’s stock owned by the controlling section 245A shareholder on the last day of the CFC’s taxable year to less than 90 percent of the shareholder’s initial percentage of such stock.[12] Similar to the extraordinary disposition rules, there is a corollary rule for extraordinary reductions with respect to a lower-tier CFC.[13]
Holding Period
To qualify for the Section 245A DRD, the domestic corporate shareholder must meet the one-year holding period requirement in section 246(c). A domestic corporate shareholder’s holding period is reduced under section 246(c)(4) for any period in which the shareholder’s risk of loss in the SFC’s stock was diminished. In the case of deemed dividends under section 964(e)(4) and section 1248, the holding period rules in those sections apply. It is important to note that except in the case of certain deemed dividends that are eligible for the Section 245A DRD, the domestic corporate shareholder must directly hold the SFC stock to satisfy the holding period and be eligible for the Section 245A DRD.
Section 245A DRD Tax Planning Opportunities
If the requirements of section 245A are met, the Section 245A DRD can be a dynamic provision for domestic corporate taxpayers to tax efficiently repatriate earnings through a dividend or a deemed dividend which may occur through sections 367, 1248, and 964(e)(4). While the result of section 245A may seem obvious because of the United States’ transition to a quasi-territorial tax system where almost all of a foreign corporation’s earnings are taxed on a current basis (even if they are not distributed back to the United States), section 245A introduces planning opportunities to repatriate certain untaxed earnings tax-free.
Prior to the TCJA, a U.S. shareholder of a CFC only currently included in income its pro rata share of the CFC’s subpart F income. Thus, any income that was not included in the U.S. shareholder’s share of subpart F income remained untaxed earnings. Those untaxed earnings were policed by section 1248 which generally provides that a U.S. person that sells or exchanges stock in a foreign corporation and such person owns (under 958(a) or (b)) 10 percent or more of the total combined voting power of all classes of stock entitled to vote at any time during the five year period ending on the date of the sale or exchange of the foreign corporation stock, the U.S. person shall include the gain recognized on the sale or exchange of the foreign corporation stock as a deemed dividend (i.e., ordinary income) to the extent of the foreign corporation’s untaxed section 1248 E&P.[14] Accordingly, section 1248 effectively served as a backstop to prevent a U.S. person that owns stock in a CFC (or a former CFC) to avoid including the foreign corporation’s untaxed E&P in income by simply selling the stock and recognizing a capital gain (at more favorable tax rates) on the sale.
Post-TCJA, section 1248 is less relevant because in the new quasi-territorial system most of a CFC’s earnings are currently includable in the income of a U.S. shareholder (either through subpart F or GILTI). However, a CFC may continue to have untaxed earnings because of the GILTI qualified business asset investment (“QBAI”)[15] exemption. Generally, the GILTI rules exclude from a U.S. shareholder’s “net tested income” 10 percent of the U.S. shareholder’s pro rata share of aggregate QBAI of its CFCs less a specified interest expense. Accordingly, any untaxed earnings that are not currently included in income because of the QBAI exemption continue to accrue as untaxed section 1248 E&P.
The TCJA also amended section 1248 by adding section 1248(j) which is a coordination provision for section 1248 stock sales and section 245A. Generally, it provides that a domestic corporation that sells stock of a foreign corporation that it held for one year or more, any amount that is received by the domestic corporation which is treated as a section 1248 deemed dividend is treated as a dividend for purposes of section 245A. Accordingly, the amendment to section 1248 expressly provides that section 1248 deemed dividends qualify for the Section 245A DRD (assuming the other requirements of section 245A are satisfied).
This coordination provision opens many planning opportunities because if a taxpayer can structure a transaction as a stock sale (or a deemed sale or exchange) of a CFC or a transaction that results in a section 1248 deemed dividend, the gain from such sale, to the extent of the section 1248 E&P, should not be taxed after the application of section 245A. Section 964(e)(4) provides similar planning opportunities where a parent CFC sells the stock of a subsidiary CFC. Under section 964(e)(4) the sale is treated as a section 1248 deemed dividend under section 964(e)(1), the foreign-source portion of the dividend is treated as subpart F income of the selling CFC, the U.S. shareholder of the selling CFC includes in its gross income the U.S. shareholder’s pro rata share of such subpart F income and, the U.S. shareholder is entitled to the Section 245A DRD with respect to its pro rata share of the selling CFC’s subpart F income as if such income was a dividend directly received by the U.S. shareholder from the subsidiary CFC. There are several taxable transactions that could be treated as section 964(e) stock sales enabling the domestic corporate shareholder to get the benefit of the Section 245A DRD.
Section 245A is a taxpayer favorable provision that can provide domestic corporate taxpayers with significant benefits. A domestic corporate taxpayer that has received a dividend or a deemed dividend of undistributed earnings from a foreign subsidiary may benefit from the exemption. Any domestic corporate taxpayer that is considering repatriating its foreign subsidiaries’ untaxed earnings should consider the impact and potential benefit of these rules.
Expert Tax Attorneys
If you need assistance analyzing section 245A or planning foreign earnings repatriation, Freeman Law can help you navigate these complex issues and repatriate your foreign earnings in a tax-efficient manner. We have experience with International and Offshore tax laws. 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 or questions.
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[1] The current U.S. tax system is described as “quasi-territorial” because it is a hybrid system. While the TCJA eliminated taxation of repatriated dividends it also expanded the taxation of income accrued within CFCs by enacting the GILTI regime as a backstop to the subpart F anti-deferral regime. Thus, despite the Section 245A DRD, the Code still taxes certain foreign income.
[2] Section 957 defines a “controlled foreign corporation” as any foreign corporation if more than 50 percent of (i) the total combined voting power of all classes of stock of such corporation entitled to vote, or (ii) the total value of the stock of such corporation is owned (within the meaning of section 958(a)), or is considered as owned by applying the ownership rules of section 958(b), by United States shareholders on any day during the taxable year of such foreign corporation.
[3] Section 245A(c)(1).
[4] Section 245A(c)(2).
[5] Section 245A(c)(3).
[6] Treas. Reg. § 1.245A(e)-1(d)(2).
[7] The term specified property means any property if gain recognized with respect to such property during the disqualified period is not described in section 951A(c)(2)(A)(i)(I) through (V). Treas. Reg. § 1.245A-5(c)(3)(iv).
[8] The term disqualified period means, with respect to an SFC that is a CFC on any day during the taxable year that includes January 1, 2018, the period beginning on January 1, 2018, and ending as of the close of the taxable year of the SFC, if any, that begins before January 1, 2018, and ends after December 31, 2017. Treas. Reg. § 1.245A-5(c)(3)(iii).
[9] Treas. Reg. § 1.245A-5(d)(1).
[10] Treas. Reg. § 1.245A-5(b).
[11] Treas. Reg. § 1.245A-5(e)(1).
[12] Treas. Reg. § 1.245A-5(e)(2).
[13] Treas. Reg. § 1.245A-5(f).
[14] The policy underlying section 1248 was to prevent U.S. shareholders of CFCs or former CFCs from selling the stock of the foreign corporation to change the character of the income (i.e., capital gain on the stock sale rather than ordinary income if the earnings had been repatriated) to obtain a favorable capital gains tax rate.
[15] QBAI is a CFC’s average quarterly basis in depreciable tangible property used in a trade or business for the production of tested income.
