Using Untaxed Foreign Earnings to Recharacterize Gain from Section 311(b) Distributions or Section 964(e) Stock Sales
Introduction: Pairing Section 311(b) Distributions or Section 964(e) Stock Sales with the Section 245A DRD
U.S. multinational corporations may be able to use untaxed foreign earnings to recharacterize gain from section 311(b) distributions or section 964(e) stock sales with the section 245A dividends received deduction (“Section 245A DRD”) to treat the gain from such transaction as a tax-free dividend to the U.S. corporate shareholder. If the corporation’s untaxed foreign earnings exceed the gain from the section 311(b) distribution or the section 964(e) stock sale, the transaction may be tax-free as a result of the Section 245A DRD. As explained in detail in our prior post, the Tax Cuts and Jobs Act, Pub. L. 115-97 (2017) (the “TCJA”) enacted section 245A which provides that the foreign-source portion of dividends received by certain domestic corporations are eligible for a dividends received deduction provided that certain requirements are met. The TCJA transitioned the United States from a worldwide tax system to a quasi-territorial tax system.[1]
As part of that transition, the United States enacted the GILTI regime as a backstop to the subpart F anti-deferral regime. Generally, under GILTI, a U.S. shareholder of a controlled foreign corporation (“CFC”) must include in its gross income the U.S. shareholder’s GILTI for a taxable year (generally, income that is not otherwise subject to U.S. tax on a current basis). Despite the subpart F and GILTI regimes, certain foreign income is excluded from GILTI and may remain untaxed, on a current basis, in the United States. These untaxed earnings represent an opportunity for taxpayers as they may be able to use those untaxed foreign earnings to recharacterize gain from a section 311(b) distribution or a section 964(e) stock sale as a dividend (and tax-free to the extent of the untaxed foreign earnings) with the Section 245A DRD.
Untaxed Foreign Earnings After the Application of Subpart F and GILTI
Generally, a U.S. shareholder of a CFC must include in income its pro rata share of the CFC’s subpart F income and GILTI. Under section 951A(b) a U.S. shareholder is subject to tax on its CFCs’ combined “net CFC tested income” which is income that is not otherwise subject to U.S. tax on a current basis or specifically excluded, that exceeds the CFC’s qualified business asset investment (“QBAI”).[2] A U.S. shareholder’s net CFC tested income is the aggregate pro rata share of tested income from each of its CFCs minus the aggregate pro rata share of tested loss from each of its CFCs (but not less than zero). Accordingly, any CFC tested income that is netted against the CFC’s tested loss remains untaxed foreign earnings because it is excluded from the U.S. shareholder’s GILTI.
As discussed, generally the underlying policy for the GILTI regime was to eliminate deferral of untaxed foreign earnings and capture any income that was excluded from subpart F or not otherwise subject to current tax in the United States. Nonetheless, a CFC may continue to have untaxed foreign earnings because of the GILTI QBAI exemption and other types of gross income that are specifically excluded from the definition of “tested income” under section 951A(c)(2)(A). Relevant items of gross income that are excluded from the definition of tested income include: (i) any gross income excluded from foreign base company income (as defined in section 954) and the insurance income (as defined in section 953) of such corporation by reason of the section 954(b)(4) high tax exception (the “GILTI high-tax exclusion”),[3] (ii) any dividend received from a related person (as defined in section 954(d)(3)) (the “related-person dividend exclusion”),[4] and (iii) any foreign oil and gas extraction income (as defined in section 907(c)(1) of such corporation (the “FOGEI exclusion”).[5]
Thus, after application of subpart F and the GILTI rules the universe of untaxed foreign earnings includes income in the following categories, (i) certain tested income that was offset by tested losses, (ii) the QBAI exemption, (iii) the GILTI high-tax exclusion, (iv) the related-person dividend exclusion, and (v) the FOGEI exclusion. As discussed below, the aggregate amount of untaxed foreign earnings from the income exclusion categories noted above is tracked under section 1248 and may be used to recharacterize a stock sale or a deemed sale as a dividend to the extent of the section 1248 earnings and profits (“E&P”).
Section 1248 and Tracking Untaxed Foreign Earnings
Prior to the TCJA, any income that was not included in a U.S. shareholder’s share of subpart F income remained untaxed foreign earnings. Those untaxed foreign 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 section 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. Accordingly, section 1248 effectively served as a backstop to prevent a U.S. person that owns stock in a CFC (or a former CFC) 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.
Determining Untaxed Foreign Earnings and Profits Attributable to Foreign Corporation Stock
A foreign corporation’s untaxed foreign earnings are described in section 1248(c) and are determined applying the rules in Treas. Reg. § 1.1248-2 in the case of E&P attributable to a block of stock in simple cases and Treas. Reg. § 1.1248-3 in the case of E&P attributable to a block in complex cases. The untaxed foreign earnings described above are tracked through a foreign corporation’s section 1248 E&P. Most importantly, any untaxed foreign earnings that are tracked under section 1248 are available to rechacterize any gain under a section 311(b) distribution or a section 964(e) stock sale as a dividend that is eligible for the Section 245A DRD. Thus, the greater the amount of a foreign corporation’s section 1248 E&P the greater the potential benefit of any transaction that recharacterizes the gain as a dividend to the extent of a foreign corporation’s section 1248 E&P.
Section 311(b) Distributions
Generally, non-liquidating distributions result in shareholder-level consequences to the distributee[6] under section 301 and corporate-level consequences to the distributor under section 311. Under section 311(a), a distributing corporation does not recognize gain or loss on distributions of property with respect to its stock (i.e., a section 301 transaction). However, section 311(b) provides that if a corporation distributes property in which the fair market value exceeds the distributing corporation’s basis in that property, then gain will be recognized as if the distributed property was sold to the distributee at its fair market value.[7]
For instance, consider a structure where FP, a foreign corporation, owns 100 percent of S, a domestic corporation, and S owns 100 percent of FC, a foreign corporation that is a CFC. The fair market value of S’s stock in FC exceeds its basis in FC. If S distributes its FC stock to FP, it should be treated as a section 301 distribution to which section 311(b) applies and under section 311(b)(1)(B) treated as if S had sold the FC stock to FP at its fair market value. Because the transaction is treated as if a U.S. person (S) sold the stock of a foreign corporation (FC), section 1248 applies to recharacterize S’s gain on the sale or exchange of the stock of FC, a CFC, including any gain recognized under section 301(c), as a section 1248 dividend to the extent of any untaxed foreign earnings attributable to such stock (i.e., the FC’s untaxed foreign earnings).[8] Additionally, under section 1248(j), any amount recharacterized as a deemed dividend under section 1248 is eligible for the Section 245A DRD, provided that the requirements of section 245A are met. Accordingly, FC’s untaxed foreign earnings enabled the gain realized by S on its distribution of the FC stock to FP to be recharacterized as a dividend and distributed tax-free under section 245A.
Section 964(e) Stock Sales
Similarly, under section 964(e) gain on sales of foreign corporation stock by an upper-tier CFC are treated as dividends. Section 964(e)(1), provides that a CFC that recognizes gain on the sale or exchange of stock in a foreign corporation includes such gain in the selling CFC’s gross income as a dividend “to the same extent that it would have been so included under section 1248(a) if such controlled foreign corporation were a United States person.” Thus, these rules look to the section 1248 untaxed foreign earnings of the lower-tier foreign corporation to determine the amount of gain that qualifies as a deemed dividend in the hands of the upper-tier CFC.
The section 954(c)(3)(A)(i) same-country dividend exception does not apply to such dividend; however, section 964(e)(4) provides a coordination rule of such dividends with the Section 245A DRD. Section 964(e)(4) provides that any amount treated as a dividend under section 964(e)(1) and where the selling CFC held the stock in the other foreign corporation for a year or more is treated as (i) the foreign-source portion of the dividend is treated as subpart F income of the selling CFC, (ii) the U.S. shareholder with respect to the selling CFC includes in its gross income for the taxable year that includes the CFC’s tax year end, the U.S. shareholder’s pro rata share of the amount treated as subpart F income, and (iii) the Section 245A DRD is allowable to the U.S. shareholder with respect to such subpart F income described in section 964(e)(4)(A)(ii) as if the subpart F income were a dividend received by the shareholder from the selling CFC.[9] Accordingly, in the case of a U.S.-parented group that has a chain of CFCs and lower-tier CFCs with untaxed foreign earnings, the U.S.-parented group may be able to plan into a section 964(e) stock sale to use the untaxed foreign earnings and the Section 245A DRD to recharacterize the gain from the stock sale as a dividend that is tax-free rather than foreign personal holding company income that should be includable to the selling CFC’s U.S. shareholder under section 951(a)(1)(A).
Conclusion
As discussed above, while the TCJA mostly eliminated deferral of untaxed foreign earnings, certain categories of foreign income remain untaxed. Taxpayers that have those categories of excluded income – tested income that was offset by tested losses, the QBAI exemption, the GILTI high-tax exclusion, the related-person dividend exclusion, and the FOGEI exclusion – may benefit from tax planning involving a section 311(b) distribution or a section 964(e) stock sale to recharacterize gain from these transactions as a tax-free dividend to the extent of the untaxed foreign earnings. The key to utilizing these planning strategies to recharacterize gain using untaxed foreign earnings is accurately measuring the amount of a foreign corporation’s section 1248 E&P and confirming that the requirements of section 311(b), 964(e), and section 245A are satisfied.
Expert Tax Attorneys
If you need assistance analyzing section 245A or planning section 311(b) distributions of appreciated property or section 964(e) stock sales, Freeman Law can help you navigate these complex issues and plan your transactions 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.
[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 global intangible low taxed income (“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] QBAI is a CFC’s average quarterly basis in depreciable tangible property used in a trade or business for the production of tested income.
[3] See section 951A(c)(2)(A)(i)(III), Treas. Reg. § 1.951A-2(c)(1)(iii). On July 23, 2020, Treasury and the IRS published final regulations in T.D. 9902 clarifying the GILTI high-tax exclusion. Generally, the final regulations provide that a “controlling domestic shareholder” of a CFC must make an election, on an annual basis, to apply the GILTI high-tax exclusion. See Treas. Reg. § 1.951A-2(c)(7)(viii)(A)(1). The election is binding on all other U.S. shareholders of the CFC and the election applies to all CFCs in a controlling domestic shareholder group. See Treas. Reg. § 1.951A-2(c)(7)(viii)(E).
[4] Section 951A(c)(2)(A)(i)(IV).
[5] Section 951A(c)(2)(A)(i)(V).
[6] At the shareholder level, the amount distributed is treated first as a dividend to the extent of the distributing corporation’s current or accumulated E&P under section 301(c)(1). Second, as a return of the distributee shareholder’s stock basis in the distributor under section 301(c)(2). And third, any remaining gain that exceeds the distributor’s current and accumulated earnings and profits and the distributee shareholder’s stock basis in the distributor, is treated as a capital gain under section 301(c)(3).
[7] Gain recognized under section 311(b) is determined on an asset-by-asset basis. Accordingly, if both appreciated and depreciated property is distributed, gain recognized on the appreciated property is not offset by loss on the depreciated property.
[8] Note that if the facts were slightly modified and FP was instead a U.S. parent corporation that owned 100 percent of the stock of S, the section 311(b) gain recognized by S should be deferred under Treas. Reg. § 1.1502-13 until it is required to be included in income under the matching rule of Treas. Reg. § 1.1502-13(c) or the acceleration rule of Treas. Reg. § 1.1502-13(d).
[9] Section 964(e)(4)(A)(i) – (iii)
