Regulations Govern Treatment of Controlled Foreign Corporations Using Partnerships

The IRS issued final regulations under Secs. 954 and 956 (T.D. 9792) that affect shareholders of controlled foreign corporations (CFCs), providing rules regarding the treatment as U.S. property of property held by a CFC in connection with certain transactions involving partnerships. In addition, the final regulations provide rules for determining whether a CFC is considered to derive rents and royalties in the active conduct of a trade or business for purposes of determining foreign personal holding company income (FPHCI), as well as rules for determining whether a CFC holds U.S. property as a result of certain related-party factoring transactions. The final regulations adopt temporary regulations (T.D. 9733) issued last year with a few clarifications in response to comments. T.D. 9792 also withdrew Rev. Rul. 90-112.

The amount that a U.S. shareholder of a CFC must include in gross income with respect to the CFC is determined under Sec. 956. This amount is partly based on how much U.S. property the CFC holds, directly or indirectly.

The regulations finalize an anti-avoidance rule, under which a CFC is considered to indirectly hold investments in U.S. property acquired by any other foreign corporation that is controlled by the CFC, if one of the principal purposes of creating, organizing, or funding that corporation is to avoid the application of Sec. 956. Despite comments suggesting the new rule is too broad, the final rules modify this anti-avoidance rule so it will apply when a foreign corporation a CFC controls is funded other than through capital contributions or debt.

Second, the regulations finalize a rule to prevent taxpayers from using partnerships to structure transactions that are similar to the types of transactions addressed by the existing regulations.

Third, the regulations finalize a rule on foreign partnership distributions funded by CFCs. The rule is aimed at taxpayers that are undertaking transactions in which a CFC lends funds to a foreign partnership, which then distributes the proceeds to a U.S. partner related to the CFC and whose obligation would be U.S. property if the CFC held it or if it was treated as held by the CFC.

The rules also finalize definitions for determining whether rents and royalties are considered derived in the active conduct of a trade or business, in which case they are excluded from FPHCI.

The IRS also issued proposed regulations (REG-114734-16), also affecting CFC shareholders, that provide rules regarding the determination of the amount of U.S. property treated as held by a CFC through a partnership.

The final regulations were effective, and Rev. Rul. 90-112 was withdrawn, on Nov. 3, 2016. The proposed regulations are proposed to be effective for tax years of CFCs ending on or after they are finalized and tax years of U.S. shareholders in which or with which those tax years end, with respect to property acquired on or after they are finalized.