Effect of the new pro rata share rules

Editor: Christine M. Turgeon, CPA

Recent changes to the rules related to the deduction for certain foreign dividends received by U.S. corporate shareholders could substantially reduce the abuse concerns that the extraordinary reduction (ER) rules were designed to address, but the ER rules’ compliance requirements remain in effect.

Background

The Tax Cuts and Jobs Act (TCJA), P.L. 115–97, introduced Sec. 245A, which allows a 100% dividends–received deduction (DRD) for certain foreign dividends received by U.S. corporate shareholders in foreign corporations. Alongside this regime, Treasury and the IRS published anti–abuse rules, including the ER rules, to prevent a perceived misuse of the DRD.

The ER rules under Regs. Sec. 1.245A–5(e) were designed to prevent U.S. shareholders from claiming the Sec. 245A DRD on controlled foreign corporation (CFC) earnings not previously subject to U.S. tax under the Subpart F and global intangible low–taxed income (GILTI) regimes. (Although the tiered ER rules under Regs. Sec. 1.245A–5(f) also were published to disallow the Sec. 954(c)(6) lookthrough exception, they are not discussed further in this item.)

An ER generally occurs when a U.S. shareholder’s ownership interest in a CFC is reduced below a specified threshold during the tax year. The preamble to the final Sec. 245A regulations (T.D. 9909) emphasized that the Sec. 245A regime could be abused when a U.S. shareholder that otherwise would benefit from the Sec. 245A DRD on a dividend received from a CFC transfers that CFC stock to either a foreign person that owns a U.S. corporation (such that, by reason of the repeal of Sec. 958(b)(4), the entity remains a CFC) or another U.S. person who, by reason of the reduction provided for dividends paid under prior Sec. 951(a)(2)(B), would not include 100% of the CFC’s Subpart F or tested income (i.e., “inclusion earnings”) attributable to the shares acquired. Under the ER rules, all or a portion of the U.S. transferor’s Sec. 245A DRD would be disallowed.

Changes to the pro rata share rules now allocate Subpart F income and tested income based on a shareholder’s period of ownership and without consideration of the payment of dividends, substantially addressing the nontaxation concerns that motivated the ER rules. As a result, the ER rules could be rendered mechanically inoperative by producing no ER amount where both the buyer and seller properly include their respective shares of CFC income. Despite the change, taxpayers still must undertake the full ER analysis to confirm that result, which could impose a compliance burden without addressing an anti–abuse concern.

Pro rata share rules

Prior to enactment of the TCJA, earnings from a CFC generally were taxed only upon repatriation, except to the extent they were subject to current inclusion under the Subpart F regime. The TCJA introduced the GILTI regime under Sec. 951A, subjecting an additional amount of a CFC’s income (i.e., tested income) to current U.S. taxation. Under both the Subpart F and GILTI regimes, a U.S. shareholder’s pro rata share of a CFC’s inclusion earnings was determined based on its proportionate interest in the CFC, measured by vote and value, on the last day of the CFC’s tax year and reduced by dividends paid by the CFC to another person. Based on this “last–day rule,” a U.S. shareholder could reduce its ownership percentage in a CFC before year–end and avoid some or all of the corresponding Subpart F or GILTI inclusion.

Example: In a tax year prior to enactment of the law known as the One Big Beautiful Bill Act (OBBBA), H.R. 1, P.L. 119–21, a U.S. shareholder that owns 100% of a CFC from Jan. 1 through Sept. 30 sells all its CFC stock on Oct. 1 to a foreign person that owns a U.S. corporate subsidiary. Assuming the CFC earns Subpart F or tested income throughout the year, the selling shareholder would have no Subpart F or GILTI inclusion for the year despite having owned the stock for nine months. If the U.S. shareholder received a dividend (or deemed dividend under Sec. 1248(a)), those earnings — before considering the ER rules — would be eligible for the Sec. 245A DRD.

Alternatively, if a U.S. person acquired the CFC stock instead, then the buyer’s pro rata share could be reduced under Regs. Sec. 1.245A–5(e) by amounts distributed to the seller prior to the sale, including deemed dividends under Sec. 1248. As a result, neither the seller nor the buyer would fully include the CFC’s income for the year, effectively converting earnings that otherwise would be subject to a Subpart F or GILTI inclusion into tax–free earnings for which a Sec. 245A DRD is allowed.

ER rules in general

The ER rules were designed to limit the Sec. 245A DRD when a CFC’s inclusion earnings could be repatriated without U.S. taxation. Under Regs. Sec. 1.245A–5(e)(2)(i), taxpayers must determine whether an ER has occurred by testing whether (1) the shareholder has transferred more than 10% (by value) of its interest in the entity (and representing at least 5% of the overall stock) or (2) the shareholder’s ownership percentage was reduced below 90% (by value) of the shareholder’s initial percentage (and representing at least 5%). If those criteria are triggered, the taxpayer must compute its prereduction pro rata share for the CFC, which is the amount of the CFC’s inclusion earnings that would have been included had the ER not occurred.

The ER amount (i.e., the amount by which the Sec. 245A DRD is disallowed) is the lesser of (1) the amount of the dividend or (2) the excess of the prereduction pro rata share over the U.S. shareholder’s actual pro rata share for the year.

Regs. Sec. 1.245A–5(e)(3)(i) provides an election to close the CFC’s tax year on the date of the ER (a year–end (YE) close election), causing the selling shareholder to include its pro rata share of the CFC’s inclusion earnings as of the date of the ER. As a result, no portion of the CFC’s inclusion earnings would avoid U.S. taxation by reason of the payment of a dividend. The election requires a written, binding agreement between the buyer and the seller. In practice, the selling shareholder’s ability to preserve the DRD depends on the buyer’s willingness to cooperate, which is not guaranteed in arm’s–length transactions.

Example (continued): Assume the CFC earns $120 of tested income ratably throughout the year. The seller’s prereduction pro rata share is $120. Its actual pro rata share is $0. Accordingly, the Sec. 245A DRD would be disallowed for dividends up to $120. If the seller and buyer enter into a written binding agreement to make the YE close election, the seller would include its pro rata share of the CFC’s inclusion earnings through Oct. 1 (likely converting most of those earnings to previously taxed earnings and profits (PTEP)). However, if the buyer is unwilling to cooperate, then the seller faces disallowance of the Sec. 245A DRD.

OBBBA pro rata share reform

The OBBBA modified the pro rata share rules under Secs. 951(a)(2) and 951A for CFC tax years beginning after Dec. 31, 2025. Under the new rules, a U.S. shareholder’s pro rata share of Subpart F and net CFC tested income (NCTI, formerly GILTI) will include only income attributable to periods during which the shareholder owned the stock of a CFC. This change replaced the prior last–day rule (including the reduction for dividends paid to another person) with a period–based allocation approach, ensuring that a CFC’s earnings are subject to U.S. tax inclusion by the shareholder to whom they are attributable.

Example (continued): Under the new rules, the seller would include its pro rata share of the CFC’s inclusion earnings through the date of the sale, and the buyer, if a U.S. shareholder, would pick up the remaining three months. Because the CFC’s inclusion earnings are included in the seller’s gross income, the Sec. 245A—eligible earnings are reduced (because those earnings, in large part, will become PTEP). Further, the payment of a dividend itself (or deemed dividend) would not affect the seller’s pro rata share, diminishing the need for the ER rules.

Compliance confirmation still needed

After the enactment of the OBBBA, the perceived gap that the ER rules were designed to address is substantially reduced for dispositions and restructurings, and the result is largely the same to the seller as when a YE close election is made. Because the seller’s actual pro rata share under the OBBBA now equals its prereduction pro rata share, the ER amount is zero. The ER rules could be viewed as unnecessary and mechanically inoperative, yet taxpayers still must undertake the compliance exercise to confirm that result and could continue to spend significant time in negotiations to allow the YE close election to be made (in the absence of final and effective guidance on the new pro rata share rules).

Treasury has been granted regulatory authority to implement the new pro rata share allocation rules, including the method for delineating income among shareholders upon a midyear disposition — a function previously served by the YE close election. Given the changes to the pro rata share rules, when issuing future guidance, Treasury could either wholly eliminate the ER rules or substantially limit their application to situations where the OBBBA’s changes have eliminated the perceived abuse of the Sec. 245A regime. The ER rules also potentially could be suspended for CFC tax years while the reformed pro rata share rules are in effect.

Editor

Christine M. Turgeon, CPA, is a partner with PwC US Tax LLP, Washington National Tax Services, in New York City.

For additional information about these items, contact Turgeon at christine.turgeon@pwc.com.

Contributors are members of or associated with PwC US Tax LLP.