New regulations for Subpart F and CFC investment in U.S. property

Editors: Mindy Tyson Weber, CPA, and Trina Pinneau, J.D., LL.M.

On Nov. 3, 2016, the IRS and Treasury issued final regulations pursuant to Secs. 954 and 956 (T.D. 9792), which generally adopted the proposed regulations and withdrew temporary regulations, both issued on Sept. 2, 2015 (REG-155164-09 and T.D. 9733, respectively). The final regulations address the treatment of U.S. properties held by controlled foreign corporations (CFCs) in certain transactions involving partnerships. Additionally, the regulations elaborate on the active rents and royalties exception to the foreign personal holding company income (FPHCI) category of Subpart F income, as well as provide guidance on whether a CFC holds or has investment in U.S. property as a result of certain related-party factoring transactions. Along with the final regulations, the IRS and Treasury issued new proposed regulations under Sec. 956 (REG-114734-16). The final regulations also make obsolete Rev. Rul. 90-112.

Subpart F income FPHCI exception modifications

Under Sec. 954, when a CFC earns FPHCI, which includes passive income such as rents or royalties, the income generally is includible in the CFC’s U.S. shareholders’ taxable incomes, even if the CFC does not distribute earnings to the U.S. shareholders. Thus, the U.S. shareholders generally cannot defer recognition of the FPHCI. However, an exception exists for so-called active rents and royalties.

The final regulations provide specific guidance on the application of the active royalty exception to the FPHCI rules under Sec. 954. Under the final regulations, royalties are not includible in the U.S. shareholders’ taxable income if the royalties are received from a party unrelated to the CFC and are earned from an active trade or business (Regs. Sec. 1.954-2(b)(6)). The IRS and Treasury will deem the royalties to have been received in an active trade or business if they meet either the active development test or active marketing test.

Under the final regulations, the active development test is met if the CFC’s officers and employees are (1) engaged in an activity that adds substantial value to the licensed property in question; and (2) regularly engaged in the development, creation, or production of, or acquisition and addition of substantial value to, the property in question (see Regs. Sec. 1.954-2(d)(1)(i)). On the other hand, the active marketing test is also met if (1) the CFC through its own officers or staff of employees located in a foreign country maintains and operates an organization in those foreign countries regularly to engage in the business of marketing, or of marketing and servicing, the licensed property; and (2) that organization is substantial in relation to the amount of royalties derived from the licensing of such property (Regs. Sec. 1.954-2(d)(1)(ii)).

Investments in U.S. property by a CFC

Under Sec. 956, a U.S. shareholder of a CFC must include in gross income the quarterly average amount of U.S. property held directly and indirectly by the CFC. Similar to Subpart F inclusions, a Sec. 956 income inclusion does not require a CFC to actually distribute its earnings to the U.S. shareholder. The amount required to be included is the adjusted basis of the U.S. property, decreased by the liabilities attached to the property. The Sec. 956 inclusion amount is further limited to the CFC’s applicable earnings (Sec. 956(a)(2)).

Final regulations pursuant to Sec. 956

Before the IRS issued the 2015 temporary regulations, the anti-avoidance rule under Temp. Regs. Sec. 1.956-1T(b)(4) provided that a CFC would be deemed to indirectly hold U.S. property when that property is acquired by any other foreign corporation that is controlled by the CFC if one of the principal purposes for creating, organizing, or funding by any means the other foreign corporation is to avoid the application of Sec. 956. The final regulations adopted the 2015 temporary regulations’ version of the anti-avoidance rule, which significantly broadened the scope of the anti-avoidance rule to apply to transactions that involve partnerships that are controlled by a CFC (Regs. Secs. 1.956-1(b)(1)(ii) and (iii)). The final regulations also include a helpful coordination rule that may help partners in a partnership with a CFC avoid the risk of being treated as holding duplicative amounts of U.S. property with respect to the same partnership property (Regs. Sec. 1.956-1(b)(3)).

The final regulations eliminate a potentially beneficial rule contained in Rev. Rul. 90-112, which held that for purposes of Sec. 956, the amount of U.S. property attributed to a CFC partner when the partner indirectly owns property through a partnership is limited by the CFC’s adjusted basis in the partnership. Treasury and the IRS concluded that this outside basis limitation was not warranted, and eliminated this rule, obsoleting Rev. Rul. 90-112. This outside basis limitation is not included in either the final regulations or the 2016 proposed regulations. Accordingly, taxpayers can no longer rely on outside basis to limit the amount of U.S. property indirectly held by a CFC through a partnership, and the amount of the inclusion resulting from an investment in U.S. property by a partnership will depend on the partner’s share of the basis that the partnership has in the property.

The IRS has determined that special allocations with respect to a partnership controlled by a U.S. multinational group (a controlled partnership) and its CFCs are unlikely to have economic significance for the group as a whole and can lead to improper tax planning. Thus, the IRS has proposed a new rule that would determine a partner’s attributable share of controlled partnership property (and the amount taken into account for Sec. 956 purposes) solely by reference to the partner’s liquidation value percentage, without regard to any special allocations (Prop. Regs. Sec. 1.956-4(b)(2)(iii), cf. Regs. Sec. 1.956-4(b)(2)(ii)).

Under the former proposed regulation, the liquidation value percentage would have been redetermined upon the occurrence of a revaluation event, which could have resulted in a significant change in the partners’ relative economic interests in a partnership (Prop. Regs. Sec. 1.956-4(b)(2)(i)). Because those interests may change significantly even in the absence of a revaluation event, the final regulations in Regs. Sec. 1.956-4(b)(2)(i) provide that a partner’s liquidation value percentage must be redetermined in certain additional circumstances even in the absence of a revaluation event (see preamble, T.D. 9792).

Obligations of foreign partnerships

Under the final regulations, obligations of foreign partnerships can be obligations of U.S. partners, and these obligations can trigger an income inclusion under Sec. 956 if the partnership obligation is derived from a CFC. The general rule in Regs. Sec. 1.956-4(c)(1) adopts an aggregate approach, which treats an obligation of a foreign partnership as a separate obligation of its partners in proportion to the partners’ interests in partnership profits. The final regulations provide that an obligation of a foreign partnership is treated as an obligation of its partners in proportion to the partners’ liquidation value percentage with respect to the partnership.

Special obligor rule in the case of certain distributions: The final regulations include a special funded distribution rule that applies when (1) a CFC makes a loan to a foreign partnership; (2) the partnership makes a distribution to a partner that is related to the CFC within the meaning of Sec. 954(d)(3), and the obligation would be treated as U.S. property if held by the CFC; (3) the partnership would not have made the distribution but for the funding of the partnership through an obligation held by the CFC; and (4) the distribution exceeds the partner’s share of the partnership obligation. The application of this rule increases the amount of the obligation that will be treated as U.S. property.

Factoring transactions: Current rules address the application of Sec. 956 to CFCs that acquire property in certain related-party factoring transactions. The final regulations also address situations where CFCs indirectly acquire receivables through a nominee, passthrough entity, or related foreign corporation.

Observations

Anti–avoidance rule: Under Temp. Regs. Sec. 1.956-1T(b)(4) (prior to the 2015 temporary regulations), a CFC would be deemed to indirectly hold investments in U.S. property held by any other foreign corporation that is controlled by the CFC if one of the principal purposes for funding, through capital contributions or debt, the other foreign corporation is to avoid the application of Sec. 956 with respect to the CFC. This is known as the anti-avoidance rule.

The 2015 temporary regulations expanded the definition to apply not only to funding through capital contributions and debt but also to all forms of funding with aprincipal purpose of avoiding the underlying policy of Sec. 956, and the final regulations retain this definition. Although this broad definition may inadvertently, or perhaps even inappropriately, subject some taxpayers to this regulation that should not be subject to it, adopting a narrower definition may encourage taxpayers to engage in improper tax planning to avoid the application of Sec. 956. While the application of this regulation relies heavily on facts and circumstances, the IRS has provided in the final regulations some examples of fact patterns that do not fall within the anti-avoidance rule. For instance, a sale of property for cash in the ordinary course of business or a repayment of a loan does not trigger the application of the rule. The rule ostensibly does not apply so long as the transaction is at arm’s length.

Partnership property indirectly held by a CFC partner, special allocations: Treasury and the IRS have revised the definition of special allocations in final Regs. Sec. 1.956-4(b)(2)(ii) to clarify that a special allocation is an allocation of book income or gain rather than a tax allocation. A special allocation means only an allocation of income (or, where appropriate, gain) from a subset of the property of the partnership to a partner other than in accordance with the partner’s liquidation value percentage in a particular tax year.

Elimination of outside basis: As mentioned previously, the final regulations obsolete Rev. Rul. 90-112. For tax years ending prior to the obsolescence of the revenue ruling, taxpayers may still rely on the outside basis limitation provided in the revenue ruling. However, for tax years ending on or after the obsolescence, taxpayers can no longer rely on outside basis to limit the amount of U.S. property held by a CFC indirectly through a partnership. Taxpayers should assess the impact of this rule on their financial statements because it may result in a year-over-year increase in tax that unexpectedly increases the effective tax rate.

Time for determining the liquidation value percentage: Taxpayers should be aware that, under the final regulations, if the liquidation value percentage determined for any partner on the first day of the partnership’s tax year would differ from the most recently determined liquidation value percentage of that partner by more than 10 percentage points, then the liquidation value percentage must be redetermined on that day, even in the absence of a revaluation event (Regs. Sec. 1.956-4(b)(2)(i)). This could result in additional administrative and compliance costs, as taxpayers may need to perform this calculation with some frequency.

Special funded distribution rule: Taxpayers should be careful to not take the position that a partnership distribution could have been made without the funding by the CFC merely by establishing that a third party would have loaned the funds needed for the partnership to make the distribution. A stronger case may need to be made to show that there is no connection between the loan and the distribution.

Effective/applicability dates

The final regulations are generally applicable for tax years of CFCs ending on or after Nov. 3, 2016. Certain sections of the final regulations have earlier effective dates, including the anti-avoidance rule of Regs. Sec. 1.956-1(b), which relates back to the 2015 temporary rule effective date of Sept. 1, 2015. The 2016 proposed regulations will be effective with respect to the tax years of CFCs ending on or after their final publication and tax years of U.S. shareholders in which or with which such tax years end and will apply only with respect to property acquired on or after the date of their final publication.

EditorNotes

Mindy Tyson Weber is a senior director, Washington National Tax for RSM US LLP. Trina Pinneau is a manager, Washington National Tax for RSM US LLP.

For additional information about this item, contact the authors at Adnan.Islam@rsmus.com or Tony.Kim@rsmus.com.

Unless otherwise noted, contributors are members of or associated with RSM US LLP.