This report examines the discussion draft’s implementation of an exemption system.
New dividends received deduction regime
A provision (section 4001) of the draft legislation would add new section 245A to the Code.
Code section 245A would entitle a domestic corporation that owns more than 10% of the voting power of a foreign corporation (ownership may be direct or indirect) to a 95% dividends received deduction against the foreign-source portion of a dividend received from such corporation (the “245A DRD”).
The portion of a dividend treated as foreign-source would be in the same proportion as the foreign corporation’s foreign-source income bears to its total earnings. A foreign corporation’s foreign earnings would be all earnings except income effectively connected to a U.S. trade or business or dividend income received from an 80% owned domestic corporation (ownership may be direct or through a wholly owned foreign corporation).
No foreign tax credit or deduction for foreign tax paid or accrued would be allowed with respect to any dividend allowed a 245A DRD. For purposes of calculating a section 904(a) foreign tax credit limitation of a domestic corporation allowed a 245A DRD, the entire foreign-source portion of the dividend is excluded from net foreign-source income. Additionally, no deductions are allocable against the exempt dividend income.
The disallowance of foreign tax credits or deductions for foreign income tax paid or accrued would apply to all income taxes paid or accrued with respect to the foreign- source portion of a 245A dividend, including applicable withholding taxes. Additionally, this disallowance would apply with respect to the entire amount of taxes paid with respect to the foreign-source portion of a dividend allowed a 245A DRD even though the 245A DRD offsets only 95% of the foreign-source portion of such dividend.
In addition to owning 10% of the voting power, a domestic corporation would need to satisfy additional requirements in order to benefit from the 245A DRD.
- The domestic corporation would have to satisfy a holding period with respect to the foreign corporation stock in order to be eligible for a 245A DRD on a dividend received from such corporation. Specifically, a domestic corporation would have to hold the shares of the foreign corporation for more than 180 days during the 361-day period beginning 180 days before the dividend is paid.
- A 245A DRD would not be permitted to the extent that the domestic corporation that owns the shares with respect to which the dividend is paid is under an obligation to make related payments with respect to positions in substantially similar or related property.
Several conforming amendments would be made to coordinate the 245A DRD with existing Code provisions.
- A 245A DRD would not be available for any dividend from a corporation exempt from tax under Code sections 501 or 521.
- Section 864(e)(3) would be amended to include a cross-reference to new section 245A. As such, for purposes of performing a U.S. shareholder’s expense allocation and apportionment, 95% of the foreign corporation stock would be considered a tax-exempt asset and excluded from the analysis.
- Section 1059 would be coordinated with new section 245A in that a corporation that receives an extraordinary dividend in respect of stock that the corporation has not held for more than two years before the dividend announcement date would be required to reduce its basis in the stock by the amount of the 245A DRD.
The 245A DRD provisions would generally be effective for tax years of foreign corporations beginning after December 31, 2014, and to tax years of U.S. shareholders in which or with which those tax years of foreign corporations end.
Loss limitation with respect to specified 10% owned foreign corporations
A provision (section 4002 of the draft legislation) would create loss limitation rules with respect to foreign corporations.
- First, through amendment to Code section 961, the proposal, solely for the purposes of determining loss, would require a domestic corporation that owns more than 10% (directly or indirectly) of a foreign corporation, to adjust its tax basis in the foreign corporation stock by reducing such basis by an amount equal to the 245A DRD received on dividends from the foreign corporation.
- Second, the legislation would add section 92 to the Code, with additional conforming amendments, that would create rules regarding income inclusions for the amounts of losses transferred in certain transactions. Under proposed section 92, if a domestic corporation transfers substantially all the assets of a foreign branch (within the meaning of section 367(a)(3)(C)) to a foreign corporation of which it is a United States shareholder, the domestic corporation would have an inclusion to gross income equal to the “transferred loss amount” with respect to such transfer.
The transferred loss amount (TLA) is defined as the excess (if any) of:
- The sum of losses incurred by the foreign branch and allowed as a deduction to the domestic corporation after December 31, 2014 and before the transfer, over
- The sum of 1) any taxable income of such branch for a tax year after the tax year in which the loss was incurred, through the tax year of the transfer, and 2) any amount recognized under section 904(f)(3) on account of the transfer.
The amount of the domestic corporation’s income inclusion under this proposal would be subject to limitations.
A domestic corporation’s gross income inclusion under this provision would be limited to the aggregate of 245A DRDs allowable to the domestic corporation, taking into account all of the domestic corporation’s 10% owned foreign corporations.
Transfer loss amounts (TLAs) excluded from gross income under this provision would be carried forward with inclusion in subsequent year’s gross income subject to this same limitation.
- For transfers covered by section 367(a)(3)(C), the TLA would be reduced by the amount of gain recognized by reason of such subparagraph.
- For transfers not covered by section 367(a)(3)(C), the TLA would be reduced by the amount of gain recognized by the domestic corporation on the transfer.
Amounts included in gross income by a domestic corporation under section 92 or by reason of section 367(a)(3)(C) would be treated as foreign source gross income. Proper adjustments to the foreign corporation’s adjusted basis or to the basis of the transferred property will be governed by future regulations or guidance.
The proposal requiring basis adjustments to a foreign corporation’s stock would be effective for dividends received after December 31, 2014.
The proposal relating to TLAs from foreign branches upon asset transfers to foreign corporations would be effective for transfers after December 31, 2014.
Transition to exemption system: treatment of deferred income
A provision (section 4003 of the draft legislation) would amend Code section 965 to subject any United States shareholder owning 10% of a foreign corporation to a deemed- repatriation of the undistributed and untaxed foreign earnings (“deferred E&P”) of foreign corporations for the last tax year of the foreign corporation ending before January 1, 2015.
Notably, the amended section 965 transition rule will apply to all U.S. shareholders that own 10% of a foreign corporation—not only shareholders who are domestic corporations.
The section 965 transition rule would create a deemed-repatriation of a foreign corporation’s deferred E&P to its 10% United States shareholders by increasing the foreign corporation’s subpart F income by the amount of deferred E&P. As such, a 10% U.S. shareholder of a foreign corporation would include in income its pro rata share of the foreign corporation’s subpart F income, which includes the increase for the deferred E&P.
The 10% U.S. shareholder would be allowed a deduction against its pro rata share of the deferred E&P inclusion by reference to the portion of the deferred E&P held in cash or liquid assets. A 90% deduction is allowed for the non-cash portion of the deferred E&P and a 75% deduction is allowed for the cash portion of the deferred E&P. Post deduction, this income inclusion will be taxed at the U.S. shareholder’s ordinary income tax rates in effect prior to the implementation of this proposal.
For example, a domestic corporation owning more than 10% of a foreign corporation would be subject to a 8.75% tax rate on deferred E&P attributable to cash and a 3.5% tax rate on all other deferred E&P.
Additionally, as deferred E&P is considered an increase to a foreign corporation’s subpart F income, for purposes of determining a U.S. shareholder’s income inclusion, a noncontrolled 10/50 company would be treated as a controlled foreign corporation.
A U.S. shareholder’s income inclusion under this transition rule would be reduced by the United States shareholder’s share of earnings deficits in the earnings of other foreign corporations it owns as of February 26, 2014.
No U.S. tax benefit for the foreign tax expense allocable to the deductible portion of the deferred E&P would be allowed, either as a credit or deduction. Correspondingly, the taxpayer would not be required to gross-up the deductible portion of the deferred E&P under section 78.
A 10% U.S. shareholder may elect to pay the tax due on the repatriated earnings in up to eight installments, subject to an acceleration rule applicable upon certain events limiting the government’s ability to collect the tax due.
The proposal also contains a special rule for the shareholders of S corporations that are themselves 10% U.S. shareholders of foreign corporations. This rule would allow the shareholders of the S corporations to elect deferral on their portion of the net tax liability from the deemed-repatriation of the foreign corporation’s deferred E&P until a triggering event occurs. Triggering events include: (1) change in S corporation status, (2) liquidation, sale, or end of the S corporation’s business, or (3) shareholder disposition of S corporation shares.
This proposal does not allow a special rule for partners in a U.S. partnership that own foreign corporation stock the option to defer the net tax liability under this transition rule. As such, U.S. shareholders that own foreign corporation stock directly or through a US partnership could consider pre-effective date planning to obtain the deferral benefit provided by this special rule for S-corporations.
Permanent extension of section 954(c)(6) look-thru rule for related CFCs
A provision (section 4004 of the draft legislation) would make permanent the exclusion from the definition of foreign personal holding company income the receipt of certain dividends, interest, rents, and royalties from related parties under Code section 954(c)(6). The amendment would be effective for the tax years of foreign corporations beginning after December 31, 2013.
While the extension of section 954(c)(6) would exclude from the definition of foreign personal holding company income the receipt of certain dividends, interest, rents, and royalties from related parties, taxpayers need to carefully analyze existing transaction flows to determine these types of related-party payments will not generate subpart F inclusions under this proposal’s updated subpart F regime. In particular, the provision creating foreign base company intangible income. While section 954(c)(6) exempts certain related-party payments from the definition of foreign personal holding company income specifically, it would not exempt similar related party payments from other types of subpart F income.
For more information, contact a tax professional with the International Corporate Services practice of KPMG’s Washington National Tax: