Unintended consequences: How a drafting glitch turned Sec. 958 upside down

By Cory Perry, CPA, Washington, and Jessica Dahlberg, J.D., Minneapolis

Editor: Greg A. Fairbanks, J.D., LL.M.

Sec. 958 is an operative section that provides constructive ownership rules. These constructive ownership rules are used in a number of places throughout the Internal Revenue Code to determine ownership of foreign entities. Prior to P.L. 115-97, known as the Tax Cuts and Jobs Act (TCJA), an analysis under Sec. 958 was relatively straightforward. One generally started at the top of an organization structure and worked one's way down to determine if an ultimate U.S. owner held directly, indirectly, or constructively sufficient interests in foreign corporations. However, that paradigm was turned upside down as a result of the TCJA. And now, what is at the bottom of the structure may be as important as what is at the top.

Through what many describe as a drafting "glitch," the TCJA completely repealed an exception to the application of the constructive ownership rules provided in pre-TCJA Sec. 958(b)(4). The legislative history suggests that the repeal was intended to be partial and surgical, but the actual legislative language simply repealed Sec. 958(b)(4) in its entirety. The overly broad repeal resulted in certain subsidiary corporations being deemed to own interests in brother/sister entities through the application of the downward attribution rules provided in Sec. 318(a)(3). In effect, lower-tier U.S. entities may now be deemed to own and control other foreign entities in the structure, causing a whole host of problems. These problems include additional compliance burdens, an expansion of entities subject to the controlled foreign corporation (CFC) rules, and income inclusions by certain ultimate U.S. investors.

This item provides an overview of the Sec. 958 constructive ownership rules, explores the root cause of this "glitch," discusses the ensuing unintended consequences, and discusses planning options to mitigate the negative effects.

Background on Sec. 958

Sec. 958 provides rules for determining stock ownership for purposes of Secs. 951 to 964. This notably includes determinations for the definition of a CFC and a U.S. shareholder, which are crucial to various international taxation regimes such as Subpart F and global intangible low-taxed income (GILTI), among others. For example, a CFC is defined in Sec. 957 as a foreign corporation that is more than 50% owned (directly, indirectly, or constructively) by U.S. persons who are U.S. shareholders. A U.S. shareholder is defined in Sec. 951(b) as a U.S. person who owns (directly, indirectly, or constructively) 10% of the voting stock of a CFC. The direct, indirect, or constructive ownership is determined using operative rules provided under Sec. 958.

Sec. 958(a) provides that stock owned means both stock owned directly and stock owned indirectly through foreign entities. Sec. 958(b) provides that, for purposes of certain sections and with certain modifications, the constructive ownership rules of Sec. 318 apply when determining stock ownership. Secs. 958(b)(1) through (3) modify the Sec. 318 rules as follows: (1) Stock owned by a nonresident alien individual will not be attributed to a U.S. citizen or resident alien individual; (2) if a partnership, estate, trust, or corporation owns more than 50% of the voting power of all voting stock of a corporation, it is deemed to own all of the stock; and (3) when attributing shares owned by a corporation to its shareholders under Sec. 318(a)(2)(C), the phrase "10 percent" is substituted for "50 percent."

Prior to the TCJA, Sec. 958(b)(4) also modified the Sec. 318 rules and provided that "Subparagraphs (A), (B), and (C) of Sec. 318(a)(3) shall not be applied so as to consider a United States person as owning stock which is owned by a person who is not a United States person." Sec. 318(a)(3) provides rules for attribution to partnerships, estates, trusts, and corporations from owners (commonly referred to as "downward attribution"). As noted, the application of these downward attribution rules was limited in scope by former Sec. 958(b)(4), which prevented the rules from attributing stock owned by a non-U.S. person to a U.S. person. This all changed in December 2017 when the TCJA repealed Sec. 958(b)(4). Now, stock owned (directly, indirectly, or constructively) by a foreign person may be subject to downward attribution to a U.S. person.

Explanation of the 'glitch'

Legislative history — including Senate floor debates — collectively indicates that the repeal of Sec. 958(b)(4) was intended to be a partial repeal. According to the final conference report, the amendment was intended to narrowly target "de-control" transactions in which the foreign parent corporation of a U.S. shareholder of a CFC causes the foreign corporation to lose its CFC status by acquiring more than 50% of the foreign corporation's stock in exchange for the contribution of cash or property. The Senate Finance Committee's explanation provided to the Joint Committee on Taxation confirmed this intended narrow scope. The Senate Finance Committee's explanation stated that the repeal of Sec. 958(b)(4) "is not intended to cause a foreign corporation to be treated as a controlled foreign corporation with respect to a U.S. shareholder as a result of [downward attribution] to a U.S. person that is not a related person (within the meaning of Sec. 954(d)(3)) to such U.S. shareholder as a result of the repeal of Sec. 958(b)(4)" (H.R. Conf. Rep't 115-466, 115th Cong., 1st Sess, p. 633 (Dec. 15, 2017) (emphasis added)). The final conference agreement follows the Senate amendment.

As articulated in the legislative history, downward attribution is only to apply when the parties in question are related under Sec. 954(d)(3). Sec. 954(d)(3) provides a person is a related person if the person is an individual, corporation, partnership, trust, or estate that controls, or is controlled by, the CFC, or the person is a corporation, partnership, trust, or estate that is controlled by the same person or persons that control the CFC. Control means, for a corporation, the ownership, directly or indirectly, of stock possessing more than 50% of the total voting power of all classes of stock entitled to vote or of the total value of stock of that corporation. In other words, the clear intent of Congress was to limit the repeal of Sec. 958(b)(4) to situations in which the U.S. shareholder controlled (or was otherwise related within the meaning of Sec. 954(d)(3) to) the U.S. person to which downward attribution from a non-U.S. person applied.

Despite clear intent, the amended Sec. 958 does not include any reference to this control/relatedness requirement, or any other indication that the repeal was intended to be anything less than a full repeal of Sec. 958(b)(4). In fact, the amended text simply repealed the existing Sec. 958(b)(4) language and did not include any additional text or limitations on the bounds of this repeal.

In Senate amendment No. 1666, Sen. David Perdue, R-Ga., proposed a clarification that would codify the Sec. 954(d)(3) limitation with respect to the repeal of Sec. 958(b)(4). Essentially, the amendment would have codified the explanatory text of the Finance Committee report to reflect that the repeal of Sec. 958(b)(4) was intended to be only a partial repeal and would still be in effect when a U.S. person is not a related person (within the meaning of Sec. 954(d)(3)) to the U.S. shareholder to which stock is attributed down to a foreign person. This amendment was not adopted.

During Senate floor debate on Dec. 19, 2017, Perdue again raised the issue that the Sec. 954(d)(3) limitation did not appear in the final text and that the repeal of Sec. 958(b)(4) was intended to be a partial repeal. On the floor, Perdue requested confirmation that the "conference report language did not change or modify the intended scope [sic] this statement [i.e., the requirement that the U.S. person be a related person (within the meaning of Sec. 954(d)(3)] ... [and] that the Treasury Department and the Internal Revenue Service should interpret the stock attribution rules consistent with this explanation of the bill" (163 Cong. Rec. S8110 (daily ed. Dec. 19, 2017)). Sen. Orrin Hatch, R-Utah, responded by stating, "the bill does not change or modify the intended scope of the statement [Senator Perdue] cites...[and] [t]he Treasury Department and the Internal Revenue Service should interpret the stock attribution rules consistent with this explanation" (id.). Hatch also noted that the reason amendment No. 1666 was not adopted was because it was not needed to reflect the intent of the Senate Finance Committee or the conferees for the TCJA.

In this exchange, the congressional intent was unmistakable. The repeal was intended to narrow an existing rule to prevent a specific abuse. It was not meant as a complete repeal of Sec. 958(b)(4). The legislative history further supports the notion that the repeal of Sec. 958(b)(4) was intended to apply only to U.S. persons related to the U.S. shareholder, within the meaning of Sec. 954(d)(3), to which downward attribution was made.

Unintended consequences abound

Notwithstanding the legislative history, the literal language included in the amended statute no longer provides a limitation on downward attribution. In light of this, many taxpayers are forced to interpret the amended statute within the literal constraints of the law — i.e., as written without the limitations inferred from the legislative history. Numerous unintended consequences result, some of which are discussed below.

The most common example is shown below in the chart "Unintended U.S. Shareholder in a CFC." Foreign Parent owns 100% of U.S. Sub and Foreign Sub. U.S. Person owns 10% of Foreign Parent, and the remaining 90% is owned by non-U.S. investors.

Unintended U.S. shareholder in a CFC

In this structure, because Foreign Parent owns 100% of U.S. Sub, U.S. Sub is deemed to own the stock that Foreign Parent owns because of downward attribution under Sec. 318(a)(3)(C). Prior to the TCJA, downward attribution would not have applied so as to consider a U.S. person (i.e., U.S. Sub) as owning stock that is owned by a person who is not a U.S. person (i.e., Foreign Parent). However, post-TCJA, no such limitation exists in the statute, and U.S. Sub may be deemed to own 100% of Foreign Sub, thus making it a CFC.

Without the integral control/relatedness requirement present in the legislative history, U.S. Person would be treated as a U.S. shareholder in Foreign Sub, which is now a CFC. This subjects U.S. Person to the Subpart F and GILTI regimes, among many other rules. This has many consequences ranging from significant compliance burdens to current taxation on foreign earnings. The consequences are further exacerbated by potential significant penalties for noncompliance with respect to Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, and by the statute of limitation for assessment under Sec. 6501(c)(8) not beginning to run until and unless the information required on Form 5471 is furnished.

Numerous other examples illustrate the collateral damage caused by the overly broad repeal of Sec. 958(b)(4). The rule change is rendering existing private-equity structures tax inefficient, creating significant new information reporting requirements, subjecting certain interest income to gross basis withholding by rendering the "portfolio interest exemption" inapplicable, and subjecting unwitting taxpayers to hosts of other complex tax rules. Yet, there are proactive measures that can be taken to limit the blowback.

Opportunities and next steps

Many taxpayers are eagerly waiting for Congress to pass a technical correction bill codifying the legislative history into Sec. 958. Technical corrections are often required when the intent was clear but not clearly reflected in the legislation. A technical correction bill generally requires 60 votes to pass the Senate. In the current political climate, obtaining the required votes may prove difficult, as Democrats are reluctant to help fix a bill they oppose without significant concessions from Republicans. In the meantime, and in the absence of congressional action, there are planning opportunities that may help mitigate the unintended consequences resulting from the repeal of Sec. 958(b)(4).

Taxpayers should consider so-called check-the-box elections for certain foreign subsidiaries. A check-the-box election is an entity classification election that allows a foreign entity to choose its entity type. For example, the flexible election allows certain foreign corporations to operate in corporate form or to be treated as disregarded as an entity separate from its owners from a U.S. tax perspective. Due to certain limits on downward attribution of one's own stock, targeted check-the-box elections may limit the impact of the repeal of Sec. 958(b)(4). Specifically, Regs. Sec. 1.318-1(b)(1) provides that a corporation cannot be considered to own its own stock by virtue of the attribution rules. As a result, a parent corporation (such as Foreign Parent in the chart) cannot be considered as owning its own stock, and by extension, none of its U.S. subsidiaries will be considered as owning its stock. By turning the subsidiary entities into branches, the foreign parent's ownership of the formerly deemed CFCs are now all treated as one entity from a U.S. perspective, and the stock of the now single parent entity cannot be attributed down to a U.S. subsidiary. Taxpayers must evaluate scores of considerations when contemplating these elections, but, in the right circumstances, those elections could provide significant relief to affected taxpayers.

Alternatively, taxpayers may consider converting U.S. subsidiaries into branches. In this case, instead of eliminating the entities that can be attributed down to a U.S. subsidiary (as in the check-the-box planning), the taxpayer eliminates the U.S. entity to which the downward attribution applies. If there are no other U.S. entities in the structure, this may prevent the CFC rules from applying. Again, this option requires significant consideration because it can result in current taxation of built-in gains and subjects the domestic operations to foreign branch rules.

There are a number of other potential options to consider as well. For example, an individual U.S. shareholder of a now-deemed CFC may consider a Sec. 962 election. This election allows individuals to be subject to tax at corporate rates, in effect, entitling the individual to pay tax as a corporation and to credit certain foreign taxes paid by the foreign entity that would otherwise not be available. This election still requires complex calculations and reporting but may limit the current tax exposure that ultimate individual U.S. investors face as a result of the repeal of Sec. 958(b)(4) in fact patterns similar to that shown in the chart "Unintended U.S. Shareholder in a CFC."

The repeal of Sec. 958(b)(4) could have far-reaching effects on a variety of taxpayers. It may be safest to assume all entities are CFCs unless proven otherwise. Existing structures should be reviewed to ensure all impacts have been identified and quantified. This detailed analysis, combined with careful proactive planning, may mitigate many of the unintended consequences resulting from the now upside-down world of Sec. 958.


Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington..

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

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