The Treasury Department and the IRS have issued final, temporary, and proposed regulations (T.D. 9733 and REG-155164-09) under Sec. 954, limiting the application of the "active rents and royalties" exception to foreign personal holding company income (FPHCI) under Sec. 954(c)(2)(A) and Sec. 956, expanding the instances in which a controlled foreign corporation (CFC) will be treated as holding U.S. property, thus increasing the likelihood of an income inclusion under Sec. 951(a)(1)(B).
The temporary Sec. 956 regulations made the following changes:
- The anti-abuse rule in Temp. Regs. Sec. 1.956-1T(b)(4) is modified to (1) be self-executing, (2) expand the scope of what constitutes a "funding" beyond a capital contribution or debt, (3) clarify that all tax attributes associated with a potential Sec. 956 inclusion (e.g., creditable foreign taxes and previously taxed earnings and profits (PTI)) are taken into account in determining whether the anti-abuse rules apply, and (4) apply also if a partnership is used with a principal purpose of avoiding the application of Sec. 956 to a CFC.
- A new rule is added to treat an obligation of a foreign partnership held by a CFC as an obligation of the partners of the partnership in certain cases when the CFC funds a distribution by the partnership to its partners. For a U.S. partner, therefore, this rule would treat all or part of the obligation as U.S. property for purposes of Sec. 956.
The temporary Sec. 954 regulations modify the active rents and royalties exception in Sec. 954(c)(2)(A) to require a CFC to perform the activities necessary for the exception to apply through its own employees. The temporary regulations further provide that certain payments made by a CFC under a cost-sharing arrangement will not cause the CFC's officers and employees to be treated as undertaking the activities of the controlled participant to which the payments are made. The temporary regulations describe this change as a "clarification" of existing law.
The proposed regulations include the provisions of the temporary regulations but propose the following additional changes under Sec. 956:
- An obligation of a foreign partnership would generally be treated as an obligation of the partners to the extent of each partner's "interest in partnership profits," which is to be determined based on all the facts and circumstances. This general rule would be superseded by a special rule in the temporary Sec. 956 regulations that increases the amount of the partnership's obligation treated as a separate obligation of a partner when a distribution exceeding the amount of the obligation that is treated as an obligation of a partner under the general rule is funded by an obligation of the partnership held by a CFC.
- A CFC that directly or indirectly guarantees an obligation of a foreign partnership that would be treated as an obligation of a U.S. person will be treated as holding that obligation of a U.S. person.
- A partnership that guarantees an obligation of a U.S. person will be treated as holding that obligation for purposes of Sec. 956, causing a CFC partner in that partnership to be treated as holding a portion of that obligation.
- A CFC partner's share of partnership property, for purposes of Sec. 956, will be determined in accordance with the CFC partner's "liquidation value percentage," which generally equals the cash distribution the partner would receive from the partnership if the partnership sold all its assets for cash, settled its obligations, and then liquidated.
- The rules treating certain receivables acquired by a partnership in a factoring transaction as constituting U.S. property for purposes of Sec. 956 are expanded.
The proposed regulations would also confirm that an obligation of an entity disregarded as separate from its single owner for U.S. federal tax purposes (a disregarded entity) is treated as an obligation of the single owner for U.S. federal tax purposes, and that an obligation of a domestic partnership is an obligation of a U.S. person.
The preamble to the proposed regulations also provides that, under current law, if more than one CFC guarantees or pledges assets with respect to the same obligation of a U.S. person, then each such CFC is treated as holding that obligation for purposes of Sec. 956. In the preamble, Treasury requests comments on whether it should adopt a rule that would limit the Sec. 956 inclusion in that case to the unpaid principal amount of the obligation.
The modifications to the anti-abuse rule of Temp. Regs. Sec. 1.956-1T(b)(4) apply to tax years of CFCs ending on or after Sept. 1, 2015, and to tax years of U.S. shareholders in which or with which those tax years end, for property acquired (including property treated as acquired as a result of a deemed exchange under Sec. 1001) on or after Sept. 1, 2015. The new rule for partnership distributions funded by a CFC applies to tax years of CFCs ending on or after Sept. 1, 2015, and to tax years of U.S. shareholders in which or with which those tax years end, in the case of distributions made on or after Sept. 1, 2015.
The temporary regulations modifying the active rents or royalties exception apply to rents and royalties received or accrued during tax years of CFCs ending on or after Sept. 1, 2015, and to tax years in which or with which those tax years end, but only for property manufactured, produced, developed, or created, or, in the case of acquired property, property to which substantial value has been added, on or after Sept. 1, 2015. The changes to the active marketing test and the rules regarding payments made under cost-sharing arrangements apply to rents or royalties received or accrued during tax years of CFCs ending on or after Sept. 1, 2015, and to tax years of U.S. shareholders in which or with which those tax years end, to the extent that those rents or royalties are received or accrued on or after Sept. 1, 2015. Further, the temporary regulations caution that no inference is intended by the effective dates of the amended provisions, and that the IRS may challenge under current law, when appropriate, transactions described in the temporary regulations.
The proposed regulations dealing with obligations of foreign partnerships, pledges or guarantees, and trade or service receivables will apply to tax years of CFCs ending on or after the final regulations' publication date and to tax years of U.S. shareholders in which or with which those tax years end, for obligations acquired, trade or service receivables acquired, or pledges or guarantees entered, on or after Sept. 1, 2015, including property considered acquired, or pledges or guarantees considered entered into, on or after the date the final regulations are published. Additionally, the proposed regulations dealing with obligations of disregarded entities and with partnership property indirectly held by a CFC are proposed to apply to tax years of CFCs ending on or after the date of publication of the final regulations, and to tax years of U.S. shareholders in which or with which those tax years end, for obligations held or property acquired on or after the date of publication of the final regulations.
Regulations Under Sec. 956
Sec. 951(a)(1)(B) generally requires a U.S. shareholder of a CFC to include in gross income for any tax year the amount determined for that CFC under Sec. 956 for that year. The amount determined under Sec. 956 for any CFC for any U.S. shareholder for any tax year is the lesser of (1) the excess (if any) of the shareholder's pro rata share of the average of the amounts of U.S. property held (directly or indirectly) by the CFC as of the close of each quarter of the tax year, over the CFC's PTI described in Sec. 959(c)(1)(A)for the shareholder, or (2)the shareholder's pro rata share of the applicable earnings of that CFC. For this purpose, U.S. property includes obligations of certain U.S. persons, including certain receivables from U.S. persons acquired in certain factoring transactions. Further, a CFC is treated as owning its share of U.S. property held by a partnership in which it is a partner, and it is treated as holding an obligation of a U.S. person for which it is a pledgor or guarantor. The temporary Sec. 956 regulations will increase the likelihood of an income inclusion under Sec. 954(a)(1)(B) by (1) expanding the anti-abuse rule of Temp. Regs. Sec. 1.956-1T(b)(4) to apply to certain transactions involving partnerships, (2) treating certain obligations of a foreign partnership as obligations of U.S. persons, and (3) increasing the scope of the factoring rule to treat receivables as obligations of U.S. persons for purposes of Sec. 956. The proposed regulations would further expand these rules.
Foreign Partnership Distributions Funded by a CFC
To address concerns with the potential use of foreign partnerships to avoid the application of Sec. 956 to a CFC, new Temp. Regs. Sec. 1.956-1T(b)(5) will treat an obligation of a foreign partnership that is held (or treated as held) by a CFC as a separate obligation of a partner if:
1. The foreign partnership distributes money or property to the partner;
2. The foreign partnership would not have made the distribution but for a funding of the partnership through the obligation; and
3. The partner is related to the CFC within the meaning of Sec. 954(d)(3).
Under this rule, the amount of the partnership obligation that is treated as a partner obligation equals the lesser of (1) the amount of the distribution that would not have been made but for the funding of the partnership, or (2) the amount of the foreign partnership obligation held (or treated as held) by the CFC.
The temporary regulations include an example illustrating this new rule but do not clearly define how to determine whether a distribution would not have been made "but for" the funding of the partnership. This arguably requires a taxpayer to prove a negative, which may be difficult, given that money is fungible. Hopefully, before issuing final regulations, Treasury will provide further guidance on how to make this determination, or at least to ensure that the same standard applies to all taxpayers during an IRS examination. These temporary Sec. 956 regulations apply to tax years of CFCs ending on or after Sept. 1, 2015, and to tax years of U.S. shareholders in which or with which those tax years end, for partnership distributions made on or after Sept. 1, 2015. Significantly, a distribution made on or after Sept. 1, 2015, that is funded by an obligation created before that date would appear to be subject to the temporary regulations.
Prop. Regs. Sec. 1.956-4(c)(3) would convert the rule in the temporary regulations into a special rule and generally provides that, for purposes of Sec. 956, an obligation of a foreign partnership will be treated as a separate obligation of a partner in accordance with that partner's interest in partnership profits. Each partner's interest in partnership profits is determined by taking into account all the facts and circumstances relating to the economic arrangements of the partners. Under the proposed regulations, therefore, the amount of the foreign partnership's obligation treated as an obligation of a partner would equal the greater of (1) the amount of the obligation treated as a partner obligation under the general rule, and (2) the lesser of any distribution to the partner that would not have been made but for the funding of the partnership and the amount of the foreign partnership's obligation.
When Prop. Regs. Sec. 1.956-4(c)(3) is finalized, Temp. Regs. Sec. 1.956- 1T(b)(5) will be removed. These proposed regulations would apply to tax years of CFCs ending on or after the date of publication of final regulations, and tax years of U.S. shareholders in which or with which those tax years end, for obligations acquired, or pledges or guarantees entered into, on or after Sept. 1, 2015.
Modifications to the Anti-Abuse Rule in Temp. Regs. Sec. 1.956-1T(b)(4)
The anti-abuse rule in Temp. Regs. Sec. 1.956-1T(b)(4) is modified to:
1. Be self-executing;
2. Expand the scope of what constitutes a "funding" beyond a capital contribution or debt;
3. Make clear that all tax attributes associated with a potential Sec. 956 inclusion are taken into account in determining whether the anti-abuse rules applies; and
4. Apply also if a partnership is used with a principal purpose of avoiding the application of Sec. 956 to a CFC.
Except for the expansion of the rule to apply to certain partnership transactions, the changes to the anti-abuse rule are consistent with positions taken in recent IRS pronouncements (see Chief Counsel Advice 201446020 and 201420017). These temporary regulations apply to tax years of CFCs ending on or after Sept. 1, 2015, and to tax years of U.S. shareholders in which or with which those tax years end, for property acquired on or after Sept. 1, 2015.
Property Held Indirectly Through a Partnership
Current Regs. Sec. 1.956-2(a)(3) provides that, for purposes of Sec. 956, a CFC that is a partner in a partnership that owns property that would be U.S. property if owned directly by the CFC is treated as holding an interest in that property equal to its interest in the partnership. The IRS has issued no further guidance on how to determine a partner's interest in the partnership for this purpose, and it is challenging to make this determination in certain cases.
To provide further clarity in this area, Prop. Regs. Sec. 1.956-4(b) would provide that a partner in a partnership is treated as holding its "attributable share" of the partnership's property. For this purpose, a partner's attributable share of partnership property is determined in accordance with the partner's liquidation value percentage, which is defined generally as the amount of cash the partner would receive if the partnership sold all its assets for cash (equal to fair market value), satisfied all its liabilities, paid an unrelated party to assume all its contingent liabilities in a taxable transaction, and then liquidated. If the partnership agreement provides for allocation of specific property that differs from a partner's liquidation value percentage, however, then the partner's attributable share of that property is determined solely by reference to that special allocation, provided the special allocation does not have a principal purpose of avoiding the purpose of Sec. 956. The proposed regulations would apply to tax years of CFCs ending on or after the date of publication of final regulations, and to tax years of U.S. shareholders in which or with which those tax years end, for property acquired on or after the date of publication of the final regulations.
Pledges and Guarantees
The proposed regulations would extend the indirect pledge or guarantee rule of current Regs. Sec. 1.956-2(c)(2) to provide that, if the assets of a partnership serve at any time, even indirectly, as security for the performance of an obligation of a U.S. person, then, for purposes of Sec. 956, the partnership will be considered a pledgor or guarantor of the obligation and therefore will be treated as holding that obligation. When the obligation is of a U.S. person, each partner in the partnership would therefore be treated as holding its attributable share of the obligation, as discussed previously. Solely by reason of being a partner in such a partnership, however, the partner would not be treated as a pledgor or guarantor for that obligation.
For any pledge or guarantee for an obligation, Prop. Regs. Sec. 1.956-1(e)(2) provides that each pledgor or guarantor is treated as holding the entire obligation to which its pledge or guarantee relates. The preamble to the proposed regulations provides that the result is then the same under current law, even if there are multiple CFC pledgors or guarantors, creating the possibility of multiple inclusions for the same obligation. The preamble requests comments, however, on whether the IRS should provide a rule to limit the inclusion to a single amount, and, if it did adopt such a rule, how the single inclusion amount would be apportioned to each CFC.
These proposed regulations apply to tax years of CFCs ending on or after the date final regulations are published, and to tax years of U.S. shareholders in which or with which those tax years end, for pledges or guarantees entered into on or after Sept. 1, 2015.
Receivables Acquired in Factoring Transactions
Generally, Sec. 956(c)(3) provides that U.S. property includes trade or service receivables acquired from a related U.S. person in a factoring transaction when the obligor is a U.S. person. Temp. Regs. Sec. 1.956-3T(b)(2) provides rules for determining whether a trade or service receivable has been indirectly acquired from a related U.S. person for purposes of Sec. 956(c)(3). The proposed regulations revise the rules that treat as U.S. property certain receivables from U.S. persons acquired from a related party to conform to the revised anti-abuse rule in Temp. Regs. Sec. 1.956-1T(b)(4) and Prop. Regs. Sec. 1.956-4(b), which treat a CFC partner as owning its attributable share of partnership property. Specifically, a CFC is treated as having "acquired" the receivable from the direct holder when the CFC is treated as holding a trade or service receivable held by another person under these rules.
These regulations also propose to remove the reference to S corporations in the rules governing factoring transactions. Prop. Regs. Sec. 1.956-3(b)(2)(ii) applies to tax years of CFCs ending on or after the date of publication of final regulations, and to tax years of U.S. shareholders in which or with which those tax years end, for trade or service receivables acquired on or after Sept. 1, 2015.
Obligations of Disregarded Entities and Domestic Partnerships
The proposed regulations provide that an obligation of a disregarded entity is an obligation of its single owner and that an obligation of a domestic partnership is an obligation of a U.S. person. This proposed regulation applies to tax years of CFCs ending on or after the date of publication of final regulations, and to tax years of U.S. shareholders in which or with which those tax years end, for obligations held on or after the date of publication of final regulations.
Regulations Under Sec. 954
Sec. 954(c)(2)(A) excludes from the scope of rents and royalties from FPHCI those derived by a CFC in the active conduct of a trade or business and received from unrelated persons. Treasury regulations define the scope of this "active rents and royalties exception," which the temporary Sec. 954 regulations generally narrow.
The temporary Sec. 954 regulations change the active rents and royalties exception to FPHCI to provide that any activities required for the exception to apply (under either the active development or market test) must be performed by the CFC's own officers or employees (Temp. Regs. Sec. 1.954-2T). The temporary regulations provide, however, that the CFC's officers or employees performing the required activities may be located in one or more foreign countries and will be taken into account for determining the substantiality of the organization for purposes of the safe-harbor test provided by the regulations.
The temporary regulations further provide that payments made by a CFC under a cost-sharing arrangement will not cause the CFC's officers and employees to be treated as undertaking the activities of the controlled participant to which the payments are made and that the related deductions of these payments are not active leasing or licensing expenses for purposes of determining whether an organization is substantial under the safe-harbor test.
The rules regarding the active development test apply to rents or royalties received or accrued during tax years of CFCs ending on or after Sept. 1, 2015, and to tax years of U.S. shareholders in which or with which those tax years end, but only for "property manufactured, produced, developed, or created, or, in the case of acquired property, property to which substantial value has been added," on or after Sept. 1, 2015. The rules regarding the active marketing test and cost-sharing arrangements apply to rents or royalties received or accrued during tax years ending on or after Sept. 1, 2015, and to U.S. shareholders in which or with which those tax years end, to the extent that such rents or royalties are received or accrued on or after Sept. 1, 2015.
Implications
The temporary Sec. 956 regulations significantly increase the instances in which a CFC may be treated as holding U.S. property (especially an obligation of a U.S. person), thus increasing the likelihood of an income inclusion to the U.S. shareholders of the CFC under Sec. 951(a)(1)(B). These changes were not unexpected, however (Treasury officials had publicly commented on the regulations project during the last several years). Although unfavorable, the temporary regulations concerning distributions from a foreign partnership funded by a CFC are arguably not over-inclusive; the requirement that the partnership distribution would not have been made "but for" the funding of the partnership by a CFC should serve to limit application of the rule. To protect against unwarranted controversy, however, taxpayers should document the source of any such distributions when the regulations might otherwise apply. Notably, the effective date of this temporary regulation is based on the date the partnership distribution is made (i.e., a distribution made on or after Sept. 1, 2015), and, therefore, the obligation that funded the distribution could have been made prior to Sept. 1, 2015. While distributions in this context must still satisfy the "but for" condition for the regulations to apply, this provision is arguably "retroactive" to a certain extent.
In contrast, when finalized, the proposed regulations treating obligations of a foreign partnership as obligations of its partners would represent a broad expansion of Sec. 956, likely resulting in inclusions even when partnership obligations are necessary for the going concern of the partnership. Treasury should reconsider the general rule of the proposed regulations, as the rule in the temporary regulations in its current form should serve to address what it might consider the most egregious case.
Taxpayers should review the debt profile of all foreign partnerships within their structure, including any associated pledges or guarantees, and monitor any potential Sec. 1001 events (including significant modifications under Regs. Sec. 1.1001-3(e)) that would treat obligations of foreign partnerships, existing prior to Sept. 1, 2015, as newly acquired and therefore potentially subject to the proposed regulations. Taxpayers may also want to review their foreign partnership agreements and equity structures to consider risk-mitigation opportunities, given the rule deems an obligation to a U.S. partner based on the U.S. partner's interest in partnership profits.
Further, although not addressed specifically, an assumption of a partner's liability by a partnership presumably is treated as a "distribution" to that partner by the partnership. If that is the case, it is unclear whether it is possible for the "but for" condition to not be satisfied in that context. Taxpayers should consider this in the context, for example, of contributions of disregarded entities with existing CFC obligations or when any subject obligations can "spring to life" for U.S. federal tax purposes as a result of the contribution.
The preamble to the proposed regulations provides that, under current law, if more than one CFC guarantees or pledges assets for the same obligation of a U.S. person, then each CFC is treated as holding that obligation for purposes of Sec. 956. It is arguably inappropriate for multiple inclusions to follow from a single obligation; the preamble would appear, however, to suggest Treasury and the IRS have no discretion under current law absent providing administrative relief, although strong policy arguments to the contrary can be made in certain fact patterns.
There may be increased administrative burdens on taxpayers if the IRS ever finalizes the proposed regulations related to U.S. property held by a CFC indirectly through the CFC's partnership interest, given that the amount of inclusion is based on the CFC partner's liquidation value percentage. This, however, may be beneficial for taxpayers when a partnership has a high-tax CFC partner determined to have a high liquidation value percentage and a low-tax CFC partner determined to have a low liquidation value percentage.
The changes to the anti-abuse rule in Temp. Regs. Sec. 1.956-1T(b)(4) are also not unexpected; except for expansion of the rule to include certain partnership transactions, most of the changes are consistent with positions taken in recent IRS pronouncements, but they do represent a material expansion of the scope of the anti-abuse rule.
Lastly, as there will be a greater possibility of investment in U.S. property determinations, it will be important for taxpayers to have command of their tax attributes (e.g., earnings and profits, deemed paid credit pools, etc.) and tax provision procedures.
A version of this item appeared in an EY Global Tax Alert.
EditorNotes
Michael Dell is a partner at Ernst & Young LLP in Washington.
For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.
