Look out for Sec. 956 inclusions

Sec. 956 results in an income inclusion to a U.S. shareholder of a controlled foreign corporation (CFC) that invests in U.S. property. Sec. 956 works as a two-edged sword that can be effectively used by both the IRS and a taxpayer. For the IRS it provides a tool for taxing U.S. shareholders on a CFC’s earnings even when the CFC does not distribute the earnings to its shareholders. Sec. 956 generally applies where a CFC makes certain investments in U.S. property.

Conversely, a U.S. shareholder may, through tax planning, cause a CFC to make such an investment. This investment may implicate Sec. 956, which may permit the U.S. person to claim a credit for foreign taxes paid by the CFC to offset the tax generated by the income inclusion.

Taxpayers who are not aware of this provision or who do not plan carefully to avoid the traps may find themselves in unexpected tax situations and subject to IRS challenges. So a caution to the unwary—be aware of Sec. 956. It is one of the more complex aspects of CFC tax law.

This article is intended to provide an introduction to Sec. 956 inclusions and is not all-inclusive with respect to the technical aspects of the statute and regulations.

Background

Sec. 951 requires certain U.S. shareholders of CFCs to include in gross income the amount of the CFC’s earnings invested in U.S. property, but only to the extent such earnings have not been previously included in a U.S. shareholder’s income under Sec. 951(a).¹ A CFC is any foreign corporation of which more than 50% of the total combined voting power of all classes of stock entitled to vote or more than 50% of the total value of its shares is owned by U.S. shareholders. Pursuant to Sec. 951(b), a U.S. shareholder is a U.S. person who owns, actually or constructively, 10% or more of the total combined voting power of all classes of voting stock of the foreign corporation.² A further discussion of Subpart F inclusions under Sec. 951 is beyond the scope of this article.

The amount of a deemed income inclusion pursuant to Sec. 956, with respect to any U.S. shareholder, is the lesser of:

• The excess, if any, of the U.S. 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 such tax year, over the amounts of earnings and profits previously included pursuant to Sec. 956; or
• The U.S. shareholder’s pro rata share of the CFC’s current and accumulated earnings and profits (but not reduced by a deficit in accumulated earnings and profits), reduced by distributions during the year and any amounts previously included under Sec. 951(a)(1)(B).³

  
  Example: USP owns all of the stock of CFC, which is a calendar-year taxpayer. During 2016, CFC has $100 of Subpart F income and $150 of earnings and profits (and no previously taxed income (PTI) from prior years). CFC makes an investment in U.S. property during January 2012 in the amount of $125. Under the Subpart F provisions, only $100 of the $150 of the earnings and profits would be includible in income, which causes the investment in U.S. property to be reduced by $100, resulting in an additional inclusion of $25.

What is U.S. property?

“U.S. property” means any property ­acquired after Dec. 31, 1962, that is:

• Tangible property located in the United States;
• Stock of a domestic corporation;
• An obligation of a U.S. person (including certain pledges or guarantees of such obligations); and
• Any right to use in the United States a patent or copyright; an invention, model, or design; a secret formula or process; or any other similar property right that the CFC acquires or develops for use in the United States.⁴

U.S. property for this purpose does not include:⁵

• U.S. government obligations, money, or deposits with:

  • (1) Any bank (defined by Section 2(c) of the Bank Holding Company Act of 1956 (12 U.S.C. §1841(c)), without regard to subparagraphs (C) and (G) of 12 U.S.C. §1841(c)(2); or

  • (2) A corporation not described in (1) above that is more than 80% owned, directly or indirectly, by vote or value, by a bank holding company.⁶

• Property located in the United States and purchased there for export to, or use in, foreign countries.⁷
• Any obligation of a U.S. person arising in connection with the sale or processing of property if the obligation’s outstanding amount during the tax year never exceeds the amount that would be ordinary and necessary to carry on the trade or business of both the other party to the sale or processing transaction and the U.S. person, if the sale or processing transaction had been made between unrelated persons.⁸
• Any aircraft, railroad rolling stock, vessel, motor vehicle, or container used in transporting persons or property in foreign commerce and used predominantly outside the United States.⁹
• Insurance company assets equivalent to the unearned premiums or reserves attributable to contracts that are not contracts described in Sec. 953(a)(1).¹⁰
• Stock or debt obligations of a domestic corporation that owns less than 10% of the CFC or a domestic corporation that is less than 25% owned in the aggregate by U.S. shareholders of the CFC.¹¹
• Any movable property (other than a vessel or aircraft) that is used for the purpose of exploring for, developing, removing, or transporting resources from ocean waters or under such waters when used on the continental shelf of the United States.¹²
• Obligations of states, state agencies, municipalities, and U.S. possessions.¹³
• Assets equal to post-1962 earnings taxed as income of a foreign corporation that are effectively connected with the conduct of a U.S. trade or business.¹⁴
• Deposits of cash or securities made or received on commercial terms in the ordinary course of a U.S. or foreign person’s business as a dealer in securities or commodities, to the extent the deposits are made or received as collateral or margin for a securities loan, notional principal contract, options contract, forward contract, futures contract, or any other financial transaction in which the IRS determines it is customary to post collateral or margin.¹⁵
• Obligations of a U.S. person, to the extent the principal amount of the obligation does not exceed the fair market value (FMV) of readily marketable securities sold or purchased under a sale and repurchase agreement or otherwise posted or received as collateral for the obligation in the ordinary course of the business of a U.S. or foreign person that is a dealer in securities or commodities.¹⁶
• Securities acquired and held in the ordinary course of its business by a CFC that is a dealer in securities if:

  •The dealer accounts for the securities as held primarily for sale to customers in the ordinary course of business; and

  •The dealer disposes of the securities (or they mature) within a period consistent with the holding of securities for sale to customers in the ordinary course of business.¹⁷

A trade or service receivable from a U.S. obligor cannot qualify under any of the exclusions described above if the CFC acquired the receivable from a related U.S. person and the obligor under that receivable is a U.S. person. This rule most often applies when a CFC factors accounts receivable of a domestic affiliate. A “trade or service receivable” is an indebtedness arising in a sale by a related person of property held for sale to customers in the ordinary course of business or from a related person’s performance of services.¹⁸

Pledges and guarantees

Sec. 956(d) may treat a CFC as holding the obligation of a U.S. person (i.e., an investment in U.S. property) if the CFC either guarantees an obligation or pledges its assets to secure the obligation. As a result, the CFC may be considered invested in U.S. property for tax purposes (even though the corporation nominally does not own any such property). If Sec. 956(d) applies, the amount of U.S. property resulting from a pledge or guarantee is the unpaid balance of the obligation in question on the determination date.

Pursuant to regulations issued under Sec. 956, a pledge of the CFC’s stock is considered an indirect pledge of the CFC’s assets if (1) at least 66 2/3% of the total combined voting power of all classes of the voting stock of the CFC is pledged; and (2) negative covenants or similar restrictions are imposed on the U.S. shareholder that effectively limit the corporation’s discretion to dispose of assets and/or incur liabilities other than in the ordinary course of business.

Given today’s complicated financing transactions, which often require multiple pledgers or guarantors with respect to the same obligation, there is a real possibility that a single U.S. obligation could easily result in multiple Sec. 956 inclusions.

What is an obligation?

For purposes of Regs. Sec. 1.956-2, the term “obligation” includes any bond, note, debenture, certificate, bill receivable, account receivable, note receivable, open account, or other indebtedness, whether or not issued at a discount and whether or not bearing interest.¹⁹ The Tax Court has held that an obligation includes payment balances in a cash management accounting system that recorded and offset all intercompany payables and receivables and reduced them to a single balance that reflected amounts due or owing to a taxpayer by its subsidiaries. The court held that “[t]his is nothing more than an open account loan.”²⁰

The IRS has provided guidance that an obligation includes the accrued but unpaid interest due on an obligation that is U.S. property under Sec. 956(c)(1)(C).²¹

However, an obligation does not include:

• Any indebtedness arising out of the involuntary conversion of property that is not U.S. property.
• Any obligation of a U.S. person arising in connection with the provision of services by a CFC to the U.S. person, if the amount of the obligation outstanding at any time during the CFC’s tax year does not exceed an amount that would be ordinary and necessary to carry on the trade or business of the CFC and the U.S. person if they were unrelated. The amount of the obligations is considered to be ordinary and necessary to the extent of the receivables that are paid within 60 days.
• Any obligation of a non-CFC foreign related person arising in connection with the provision of services by an expatriated foreign subsidiary to the non-CFC foreign related person, if the amount of the obligation outstanding at any time during the tax year of the expatriated foreign subsidiary does not exceed an amount that would be ordinary and necessary to carry on the trade or business of the expatriated foreign subsidiary and the non-CFC foreign related person if they were unrelated. The amount of the obligations is considered to be ordinary and necessary to the extent of the receivables that are paid within 60 days.
• Unless a CFC applies the exception immediately below to the obligation, any obligation of a U.S. person that is collected within 30 days from the time it is incurred (a 30-day obligation), unless the CFC that holds the 30-day obligation holds for 60 or more calendar days during the tax year in which it holds the 30-day obligation any obligations that, without regard to the exclusion described herein, would constitute U.S. property; or
• Unless a CFC applies the exception immediately above with respect to the obligation, any obligation of a U.S. person that is collected within 60 days from the time it is incurred, unless the CFC that holds the 60-day obligation holds for 180 or more calendar days during the tax year in which it holds the 60-day obligation any obligations that, without regard to the exclusion described herein, would constitute U.S. property.²²

U.S. property held indirectly through a partnership

The IRS has issued final regulations under Sec. 956 that affect shareholders of CFCs, which provide certain rules concerning the treatment as U.S. property of property held by a CFC in connection with certain transactions involving partnerships.²³ If the CFC is a partner in a partnership that owns property that would be U.S. property if owned directly by the CFC, the CFC will be treated as holding an interest in that property.

Under the regulations, the adjusted basis in the property of the partnership in the hands of a partner is equal to the partner’s attributable share of the partnership’s adjusted basis in the property, considering Sec. 743(b) or 734(b) basis adjustments and any similar basis adjustments.²⁴ This includes an obligation that the partnership is treated as holding as a result of a direct or indirect pledge or guarantee.

A partner’s attributable share of partnership property is determined in accordance with the partner’s liquidation value percentage. The liquidation value of a partner’s interest is the amount of cash the partner would receive from the interest if, on the applicable determination date, the partnership sold all of its assets for cash equal to the FMV of its assets and satisfied all of its liabilities,²⁵ paid an unrelated third party to assume all of its liabilities²⁶ in a fully taxable transaction, and finally liquidated.

A partner’s liquidation value percentage is the ratio (expressed as a percentage) of the liquidation value of the partner’s interest in the partnership, divided by the aggregate liquidation value of all of the partners’ interests in the partnership.²⁷

The determination date with respect to a partnership is the most recent of:

• The formation of the partnership;
• An event described in Regs. Sec. 1.704-1(b)(2)(iv)(f)(5) or Regs. Sec. 1.704-1(b)(2)(iv)(s)(1) (a revaluation event), irrespective of whether the capital accounts of the partners are adjusted in accordance with Regs. Sec. 1.704-1(b)(2)(iv)(f); or
• The first day of the partnership’s tax year, as determined under Sec. 706, provided the liquidation value percentage determined for any partner on that day would differ from the most recently determined liquidation value percentage of that partner by more than 10 percentage points.²⁸

Foreign tax credit and Sec. 78 gross-up

Typically, to receive a foreign tax credit, a U.S. taxpayer must have actually paid the foreign tax. But there is an exception to this rule: If a U.S. corporation has a subsidiary, then the subsidiary, rather than the U.S. taxpayer, pays the tax. In this scenario, to avoid a double tax on foreign income, the government allows the U.S. parent to claim a deemed paid foreign tax credit. This is a credit for the taxes attributable to a dividend the subsidiary (actually) pays to the parent that is attributable to the subsidiary’s foreign earnings.²⁹ For this purpose, only a domestic C corporation that owns 10% or more of the voting stock of the CFC and receives a dividend distribution from that CFC is deemed to have paid the foreign taxes.³⁰ It is important to note that this deemed credit is not available to individuals or S corporations.

A domestic corporate shareholder of a CFC may claim deemed paid foreign tax credits for foreign taxes paid or accrued by the CFC on its undistributed income, including Subpart F income, and for Sec. 956 inclusions, to offset or reduce U.S. tax on income. However, the amount of foreign taxes deemed paid on earnings of a lower-tier CFC that is a member of a qualified group included in the gross income of a domestic corporation (tentative tax) cannot exceed the amount of foreign taxes that would be deemed paid if cash in an amount equal to the amount of the inclusion in gross income were distributed in a series of distributions through the upper-tier foreign corporations to the domestic corporation (hypothetical tax).³¹ The U.S. shareholder must gross up, under Sec. 78, the amount of the income inclusion by the amount of the deemed paid foreign income taxes.³² A further discussion of the foreign tax credit and Sec. 78 gross-up provisions is beyond the scope of this article.

Basis adjustments and previously taxed income

The U.S. shareholder’s tax basis in the shareholder’s CFC is adjusted under Sec. 961 by the amount included under Sec. 951(a).³³ Since the CFC has not actually distributed the earnings, the value of the stock does not reflect the inclusion. Absent this provision, the U.S. shareholder would be effectively double-taxed on the same income upon a sale of the shares.

A U.S. shareholder of a CFC is required to include in its gross income its pro rata share of the CFC’s Subpart F income and/or the amount determined under Sec. 956 with respect to that shareholder, regardless of whether any actual distributions are made to the shareholder. Because this income was taxed when earned, it is not included in the shareholder’s income when the earnings are subsequently distributed. These amounts are characterized as PTI.

The distribution of the PTI removes the double-tax issue, and so Sec. 961(b) reduces basis by a distribution of PTI associated with earnings previously included by the shareholder under Sec. 959(a).³⁴

Earnings of a CFC that have given rise to a deemed income inclusion to the U.S. shareholder are referred to as PTI of the CFC. Sec. 959(a) protects taxpayers from being taxed a second time on an actual distribution, or investment in property, attributable to PTI of a CFC.

A further discussion of the above provisions is beyond the scope of this article.

Sec. 956: Full of surprises for the unwary

Sec. 956 and its complications can catch many tax advisers by surprise. Tax advisers and professionals involved in merger and acquisition tax due-diligence projects should be cognizant of the traps for the unwary contained in Sec. 956.³⁵ When multinational enterprises structure their intercorporate borrowings and when banks negotiate loan agreements with U.S. borrowers, all of the parties should understand the potential impact of the Sec. 956 provisions. Tax planning issues could emerge in situations involving loans to the U.S. parent, or if a bank seeks credit support from any of the foreign subsidiaries of the U.S. borrower as collateral for the debt. This collateral may take the form of either pledges by the U.S borrower of the subsidiaries’ stock and/or guarantees from foreign subsidiaries of the U.S. borrower.  

Footnotes

¹Sec. 951(a)(1)(B).

²See also Secs. 957(a) and (c).

³Sec. 956(a).

⁴Sec. 956(c)(1).

⁵This list is not all-inclusive.

⁶Sec. 956(c)(2)(A).

⁷Sec. 956(c)(2)(B).

⁸Sec. 956(c)(2)(C).

⁹Sec. 956(c)(2)(D).

¹⁰Sec. 956(c)(2)(E).

¹¹Sec. 956(c)(2)(F).

¹²Sec. 956(c)(2)(G).

¹³Rev. Rul. 71-14 and Rev. Rul. 72-454.

¹⁴Sec. 956(c)(2)(H).

¹⁵Sec. 956(c)(2)(I).

¹⁶Sec. 956(c)(2)(J).

¹⁷Sec. 956(c)(2)(K).

¹⁸Sec. 956(c)(3); Sec. 864(d)(3).

¹⁹Temp. Regs. Sec. 1.956-2T(d)(2).

²⁰Gulf Oil Corp., 87 T.C. 548 (1986).

²¹Chief Counsel Advice 201436047.

²²Temp. Regs. Secs. 1.956-2T(d)(2)(i)-(v).

²³T.D. 9792, issued in November 2016.

²⁴Regs. Sec. 1.956-4(b)(1).

²⁵Other than its Regs. Sec. 1.752-7 liabilities.

²⁶Under Regs. Sec. 1.752-7.

²⁷Regs. Sec. 1.956-4(b)(2)(i)(A).

²⁸Regs. Sec. 1.956-4(b)(2)(i)(B).

²⁹Secs. 902 and 960.

³⁰Sec. 902.

³¹Sec. 960(c)(1). See also Sec. 902.

³²Sec. 78; Regs. Sec. 1.960-3(a).

³³Regs. Sec. 1.961-1.

³⁴Regs. Sec. 1.961-2.

³⁵E.g., failure to file the proper information returns could result in an open statute of limitation under Sec. 6501(c)(8) on the entire tax return (i.e., not limited to just the information-reporting omission).