Under Secs. 951-964, certain income of a controlled foreign corporation (CFC), referred to as Subpart F income, is included in the income of its U.S. shareholders as earned before the income is actually distributed to the U.S. shareholders. Sec. 952(c)(1)(A) limits this Subpart F income inclusion by the U.S. shareholders to the extent of the CFC's current-year earnings and profits (E&P).
When a Subpart F income inclusion is limited by the CFC's current-year E&P, Sec. 952(c)(2) requires establishment of a recapture account whereby Subpart F income is recaptured in subsequent years during which the CFC has current-year E&P exceeding Subpart F income. Specifically, if Subpart F income was reduced by Sec. 952(c)(1)(A), any excess of the CFC's E&P in a subsequent tax year over its Subpart F income for that year is recharacterized as Subpart F income.
Regs. Sec. 1.952-1(f) provides that the amount of Subpart F income in each separate category of income (as defined in Regs. Sec. 1.904-5(a)(1), which refers to Sec. 904(d)(1)) that is reduced by Sec. 952(c)(1)(A) constitutes a recapture account. In any subsequent year in which E&P exceeds Subpart F income, the recapture account in each separate category will be recharacterized, on a proportionate basis, as Subpart F income to the extent of the excess. An amount that is recharacterized is treated as income in the same separate category as the recapture account from which it was derived. Under Regs. Sec. 1.952-1(f)(2)(iii), each recapture account (and post-1986 undistributed earnings for calculating foreign tax credits) will be reduced either (1) by amounts recaptured or (2) by "any distribution" out of that account (as determined under the ordering rules of Sec. 959(c) and Regs. Sec. 1.952-1(f)(3)(ii)).
A question arises as to whether the Subpart F income recapture account is reduced when the CFC has a Sec. 956 investment in U.S. property that causes its shareholder to have a Sec. 956 inclusion in a subsequent year before the Subpart F income recapture account is fully recaptured. Although treated from a policy perspective as a disguised dividend, a Sec. 956 inclusion is not literally a distribution or a dividend. In addition, the preamble to the proposed Sec. 952 regulations makes it clear that the distribution referred to in Regs. Sec. 1.952-1(f) means an actual distribution:
Under paragraph (f), a recapture account is reduced either when amounts in the account are recharacterized as Subpart F income or when the corporation makes an actual distribution from the separate category containing the recapture account. [60 Fed. Reg. 46548, at 46549 (emphasis added)]
However, in certain cases, not reducing the Subpart F income recapture account upon a Sec. 956 inclusion could allocate more income to the passive basket of the U.S. shareholders over time.
Example: In year 1, a CFC has accumulated E&P of $60 in the general basket and $0 in the passive basket, current-year E&P of negative $20 in the general basket, and $10 in the passive basket that is Subpart F income. Because the CFC has no positive current-year E&P (‒$20 + $10 = ‒$10), under Sec. 952(c)(1) there is no Subpart F income inclusion by its U.S. shareholders. Instead, the CFC must establish a Subpart F income recapture account of $10, to be recaptured in later years when the CFC's current-year E&P is positive. At the beginning of year 2, the CFC has accumulated E&P of $40 in the general basket ($60 of cumulative E&P at the beginning of year 1 ‒ $20 of current-year deficit in year 1 = $40), and $10 in the passive basket ($0 of accumulated E&P at the beginning of year 1 + $10 of current-year E&P in year 1 = $10). Assume that in year 2, the CFC has a current-year E&P deficit of $10 in the general basket, no current-year E&P in the passive basket, and a Sec. 956 investment in U.S. property of $20. Even though the CFC does not have any current-year E&P, it has sufficient accumulated E&P, so its U.S. shareholders would have a Sec. 956 inclusion of $20 in year 2.
If one takes the approach that a Sec. 956 inclusion functions like a deemed dividend and should be treated as a distribution for purposes of Regs. Sec. 1.952-1(f)(2)(iii), the Subpart F income recapture account would be reduced from $10 to zero by the Sec. 956 inclusion, as would the E&P in the passive basket in year 2. Therefore, $10 of the Sec. 956 inclusion of $20 would be in the passive basket, while the remaining $10 of the Sec. 956 inclusion of $20 would be treated as general limitation income. Taking this approach, the total amount of passive income inclusion of U.S. shareholders would be $10.
If, however, Regs. Sec. 1.952-1(f)(2)(iii) does not apply here and the Sec. 956 inclusion does not reduce the Subpart F income recapture account because only actual distributions—and not Sec. 956 inclusions—reduce the Subpart F income recapture account, then the CFC's Subpart F income recapture account remains $10, to be recaptured in the future. The Sec. 956 inclusion of $20 in year 2 still would be basketed under the normal Sec. 904(d) rules. Specifically, under Regs. Sec. 1.904-5(c)(4), the inclusion amount would be allocated proportionately to the amounts of the CFC's passive basket and general basket income accordingly, resulting in general basket income of $15 ([$20 × $30] ÷ $40) and passive basket income of $5 ([$20 × $10] ÷ $40).
Assuming that the CFC has current-year E&P of $10 in year 3, it would be required to recharacterize E&P of $10 as Subpart F income in year 3. This approach effectively causes the CFC's U.S. shareholders to include total passive income of $15 over years 2 and 3, that is, additional passive income of $5. If, instead, the CFC has sufficient current-year E&P in year 2, triggering the recapture, or the CFC makes a distribution of $10 in year 2 (an amount equal to or exceeding the recapture account), its U.S. shareholders would have only a passive income inclusion of $10, even with the Sec. 956 inclusion in year 2.
Therefore, treating a Sec. 956 inclusion as not a distribution for purposes of Regs. Sec. 1.952-1(f)(2)(iii) leads to unintended results under certain fact patterns. One may argue that Treasury has not provided a rule governing the Subpart F income recapture for Sec. 956 inclusions, probably due to an oversight, and not because Sec. 956 inclusions should not be treated the same way as actual distributions for this purpose. One can question whether taxpayers may fill in the blank, given the policy of the rule, by treating a Sec. 956 inclusion the same way as an actual distribution for purposes of Regs. Sec. 1.952-1(f)(2)(iii).
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
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