Temporary Regulations Limit Foreign DRD and Look-Through Exception

On June 18, the IRS issued temporary regulations on the limitation on the dividends received deduction (DRD) from certain foreign corporations under IRC Section 245A (foreign DRD) and amounts eligible for look-through exception under IRC Section 954(c)(6), both enacted under the Tax Cuts and Jobs Act (TCJA).

Background

Under IRC Section 245A, dividends paid by a specified foreign corporation (SFC) out of earnings that have not been subject to U.S. tax to a corporate U.S. shareholder are effectively tax-free. When Congress enacted the TCJA, it intended that the transition tax, the Subpart F regime, the global intangible low-taxed income (GILTI) provisions, and the foreign DRD, together, form an integrated set of tax rules applicable to the earnings of foreign corporations with requisite levels of U.S. ownership.

Because Congress intended to tax foreign earnings subject to the transition tax, the Subpart F regime, and the GILTI provisions, the foreign DRD does not apply to these inclusions. Rather, the foreign DRD is designed to operate residually, such that the deduction generally applies to any earnings of a controlled foreign corporation (CFC) to the extent that they are not first subject to the Subpart F regime, the GILTI provisions, or an exclusion under IRC Section 245A(c)(3).

Temporary regulations

The temporary regulations deny all or a portion of the foreign DRD in the case of transactions the U.S. Department of the Treasury and the IRS believe are intended to avoid the consequences of the integrated international provisions enacted by the TCJA. The amount of the foreign DRD that is disallowed (the “ineligible amount”) is the sum of the extraordinary disposition amount and the extraordinary reduction amount.

The extraordinary disposition amount is the amount of a distribution resulting from an extraordinary disposition. An extraordinary disposition is a disposition that is:

• From an SFC to a related party
• Of specified property, which is any property except property that generates income effectively connected with a U.S. trade or business, Subpart F income, income that is excluded from Subpart F under the de minimis or high-tax exception, or foreign oil and gas extractions income
• Made during the SFC's GILTI gap period (the period after Dec. 31, 2017, but before the distributions are subject to GILTI), when it was a CFC
• Made outside of the ordinary course of the SFC's activities

Only 50% of the extraordinary disposition amount is included in the ineligible amount. The 50% limitation reflects the potential deduction the U.S. shareholder would have been allowed under the GILTI provisions or as a transition tax deduction under IRC Section 965(c) had the earnings been subject to the transition tax. Dispositions are not extraordinary dispositions if they do not exceed the lesser of $50 million or 5% of the gross value of the SFC's property.

The extraordinary reduction amount is created when either of the following occurs:

• The controlling IRC Section 245A shareholder (generally, a U.S. corporate shareholder that owns more than 50% of a CFC) transfers more than 10% of its stock (by value) of the CFC.
• There is a greater than 10% dilution in the controlling IRC Section 245A shareholder's overall ownership of the CFC.

For example, an extraordinary reduction occurs if the controlling IRC Section 245A shareholder owns 90% of the stock of the CFC and it transfers stock representing more than 9% of the stock of the CFC. An extraordinary reduction also occurs if the controlling IRC Section 245A shareholder owns 90% of the stock of the CFC and, as a result of an issuance to a foreign person, the shareholder's ownership of the CFC is reduced such that it no longer owns at least 81% of the stock of the CFC.

An extraordinary reduction, unlike the extraordinary disposition, is not limited to a foreign corporation’s GILTI gap period. Furthermore, 100% of the extraordinary reduction amount is included in the ineligible amount. A reduction with respect to a CFC is not an extraordinary reduction if the sum of the CFC’s Subpart F income and tested income for purposes of GILTI do not exceed the lesser of $50 million or 5% of the CFC’s total income for the year. Affected taxpayers can make an election to close the CFC’s taxable year on the day before the extraordinary reduction and thereby avoid an extraordinary reduction with respect to the CFC for that year.

The temporary regulations also provide limitations on the application of Section 954(c)(6) look-through treatment for transactions to prevent frustration of the foreign DRD rules when the shareholder is another CFC rather than a U.S. shareholder.