International Tax Update 2.0

By Paul Tadros and Marc Schwartz — Schwartz International


Let’s get something straight. Our last blog rated the latest tax bill as Two Thumbs Down and concluded that America deserves better. We do deserve better. Upon reflection, we think the law is a net positive; however, there are substantive complexities which will invariably result in higher administrative costs. Furthermore, the complex provisions require regulations to be promulgated and, given the cutbacks at the IRS, guidance could be delayed – those parts are the large negative.

For any of you international tax nerds, here’s our preliminary input on the new dividends received deduction (“DRD”) for foreign dividends. The first blog applauded this rule, which creates essentially a 100% DRD for certain dividends from foreign corporations. [See new Internal Revenue Code Section (“§”) 245A.] So, how’s it work? Suppose you have a US company (“USCo”) taxed as a corporation (you know the drill, tax paid at the corporate level and then again to the shareholder on a distribution). Suppose USCo owns at least 10% of a foreign company, ForCo. The new law allows a deduction equal to the foreign-source portion of the dividend. Let’s assume ForCo only generates foreign source income; the general result is the entire dividend is not subject to US tax. That’s a great rule and puts the US on more of a territorial taxation base, comparable to many other industrialized countries. Yes, there’s other arguably outdated provisions such as the continuation of anti-deferral rules (such as Subpart F and §956), but at least it’s a big step in the right direction. We’re still not convinced the change will result in more US jobs – but it’s a good provision nevertheless.

To qualify, ForCo must be a specified 10% owned ForCo. New §245A(b)(1) defines this type of ForCo as one where any domestic corporation is a US Shareholder with respect to ForCo. US Shareholder under “old” law is a US person (as defined in §957(c)) who owns (within the meaning of §958(a)), or is considered as owning by applying the rules of ownership of §958(b), 10% or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation. The new law expands the definition to include value as well as vote. So, what’s not a specified ForCo? A passive foreign investment company (“PFIC”) that is not a controlled foreign corporation (“CFC”). We’re not going into all these details because we assume the readers have some sort of international tax background. In super general terms, a CFC is a ForCo where US Shareholders in the aggregate own at least 50% of its vote or value. So, a PFIC that’s not a CFC is tainted and the DRD doesn’t apply.

In any case, there is not a foreign tax credit or deduction related to dividends qualifying for the DRD – and that makes sense.

As stated in the first blog, hybrid dividends have separate rules – §245A(e). The DRD doesn’t apply to a dividend from a CFC if there’s a hybrid dividend. Note: The rule doesn’t say any hybrid dividend is tainted – it says from a CFC. §245A(e)(1). The intent, it seems, is an adoption of the BEPS provision dealing with hybrid instruments. Suppose there’s a USCo owning 10% of the value of ForCo and zero vote. Why should USCo be penalized if ForCo is a CFC? It has zero control in any case.

§245A(e)(4) defines hybrid dividend as a distribution otherwise qualifying for the DRD and for which the CFC received a deduction (or other tax benefit) with respect to income, war profits or excess profits taxes imposed by any foreign country or possession of the US. So, if USCo and ForCo structure a financing instrument that is equity for US purposes but debt for foreign purposes, the distribution does not get the DRD benefits in the US because it’s deductible to ForCo. As you likely know, the §385 regulations issued earlier this year were earmarked for review. Except for a relaxation of the documentation requirements, it is not clear what other major revisions, if any, will be made and the interaction with the new aforementioned hybrid rule. Again, complexity is being added.

The rules also consider tiered ownership structures. §245A(e)(2) contemplates a situation where USCo is a US Shareholder of both a CFC and a lower-tier CFC (suppose CFC wholly owns CFC 2 for our example), and CFC 2 distributes a hybrid dividend to CFC. Then, the hybrid dividend is Subpart F income to CFC in the year received and taxable to USCo, regardless of whether distributed to USCo. §245A(e)(3) provides what we see as a penalty – it disallows a foreign tax credit or deduction to USCo related to any hybrid dividend. It’s a punitive result because: (1) No DRD is allowed; (2) It’s Subpart F income; and (3) Unlike with general Subpart F income recognized by a USCo, a foreign tax credit or deduction is prohibited. [Note: This is where Congress seems to be helping the OECD’s BEPS (base erosion and profit shifting) plan.]

Regulations? We are consistently and seemingly constantly asked about details of the new law on international business and individual taxation. Well, §245A(g) ends with a grant of authority to prescribe such regulations or other guidance as may be necessary or appropriate to carry out the provisions of this section, including regulations for the treatment of US Shareholders owning stock of a specified 10% owned ForCo through a partnership. So, as with many of the new provisions, it’s wait-and-see until regulations are issued before we have all the relevant guidance. This could take some time, so don’t hold your breath.

How about holding period? We had to read this about 5 times before making sense of it. As stated in the Conference Report, the new law modifies §246(c) by essentially stating a domestic corporation is not permitted a DRD in respect of any dividend on any share of stock that is held by the domestic corporation for 365 days or less [Note: The grammarian in our brains says the Report should say fewer, but let’s not quibble, as we might be wrong!] during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to the dividend. For this purpose, the holding period requirement is treated as met only if the specified 10-percent owned foreign corporation is a specified 10-percent owned foreign corporation at all times during the period and the taxpayer is a U.S. shareholder with respect to such specified 10-percent owned foreign corporation at all times during the period.

Other items of interest? §904(b) is amended to provide that USCo’s foreign source income excludes the DRD amount. That makes sense – it’s just that Congress didn’t write it as clearly as that summary.

So, there’s a lot more to review and digest, and we’ll get to that later. One of the other items worth noting is that a general §1248 transaction with all or a portion of the sales price recharacterized as a dividend results in a taxpayer-favorable DRD to the USCo seller (even if it results from CFC selling CFC2’s stock). There’s a related basis adjustment rule in a new subsection, (d), to §961 impacting USCo if it receives a dividend qualifying for the §245A DRD. Solely for purposes of determining loss on any subsequent disposition of stock of ForCo, the basis of USCo in such stock is reduced (but not below zero) by the amount of the §245A deduction. Of course nothing is super easy, so new §961(d) ends with the following, providing there is no basis reduction to the extent such basis was reduced under section 1059 by reason of a dividend for which such a deduction was allowable. §1059 is titled Corporate shareholder’s basis in stock reduced by nontaxed portion of extraordinary dividends. We don’t see this provision in action every day. In any case, all this cross-referencing is a clear indicator the tax law is convoluted.