The OBBBA Makes Look-Through Guidance Relevant Again

0 0 17 minutes read

📝 usncan Note: The OBBBA Makes Look-Through Guidance Relevant Again

Disclaimer: This content has been prepared based on currently trending topics to increase your awareness.

House Lawmakers Work On Final Passage Of Signature Budget Bill

The One Big Beautiful Bill Act (P.L. 119-21) has made permanent a long-standing rule that provides an exception from subpart F status for income allocable to a related corporation’s nonsubpart F income or income not effectively connected to a U.S. business. After several extensions over two decades, the rule in section 954(c)(6) was set to expire at the end of 2025. Now it will not expire at all. Most of the general guidance on section 954(c)(6) is in a 2007 notice, but a regulation cross-references six provisions in which the exception’s availability is limited.

Section 952(a)(2) defines subpart F income to include foreign base company income, which is defined in section 954. Under section 954(a)(1), foreign base company income includes foreign personal holding company income (FPHCI) determined under section 954(c) (and reduced by allocable deductions under section 954(b)(5)).

Section 954(c)(1)(A) defines FPHCI to include dividends, interest, royalties, rents, and annuities.

Section 954(c)(6) provides a look-through rule for related controlled foreign corporations. Under the general rule in subparagraph (c)(6)(A), for purposes of section 954(c), dividends, interest, rents, and royalties received or accrued from a CFC that is a related person are not treated as FPHCI to the extent attributable or properly allocable to income of the related person that is neither subpart F income nor treated as effectively connected income with the conduct of a trade or business in the United States.

Whether income is attributable or allocable to other income is determined under rules similar to those in section 904(d)(3)(C) and (D). Under those provisions, interest, rents, or royalties received from a CFC in which the taxpayer is a U.S. shareholder are treated as passive category income to the extent allocable (under regs) to passive category income of the CFC. Also, dividends paid out of the earnings and profits of a CFC in which the taxpayer is a U.S. shareholder are treated as passive category income in proportion to the ratio of E&P attributable to passive category income to total E&P.

Subparagraph (c)(6)(A) further provides that interest includes factoring income that is treated as income equivalent to interest under subparagraph (c)(1)(E). It also instructs the Treasury secretary to prescribe regs necessary to carry out paragraph (c)(6), including regs necessary to prevent the abuse of its purposes.

An exception in subparagraph (c)(6)(B) provides that subparagraph (A) does not apply to interest, rents, or royalties to the extent they create or increase a deficit that may reduce the subpart F income of the payer or another CFC under section 952(c).

Under subparagraph (c)(6)(C), subparagraph (A) applies to tax years of foreign corporations beginning after December 31, 2005, and before January 1, 2026, and to tax years of U.S. shareholders in or with which the tax years of foreign corporations end.

OBBBA

Section 70351 of the OBBBA, titled “Permanent Extension of Look-Thru Rule for Related Controlled Foreign Corporations” amends section 954(c)(6)(C) by removing the reference to tax years before January 1, 2026. As a result, the look-through rule applies to tax years of foreign corporations beginning after December 31, 2005, and to tax years of U.S. shareholders in or with which the tax years of foreign corporations end. The effective date of this amendment is tax years of foreign corporations beginning after December 31, 2025.

Section 954(c)(6)(C) was added to the code in 2006 by the Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222). It originally applied to tax years of foreign corporations beginning after December 31, 2005, and before January 1, 2009. In the 14 years between 2006 and 2020, the expiration date was extended seven times, most recently to January 1, 2026, by Division EE of the Consolidated Appropriations Act of 2021 enacted on December 27, 2020 (P.L. 116-220). The OBBBA eliminates the expiration date altogether. Because this rule will no longer expire at the end of 2025, guidance on the rule deserves another look.

Published August 27, 2020, T.D. 9909 provides regs mainly under section 245A but did contain one provision under section 954(c)(6). These final regs were preceded by temporary (T.D. 9865) and proposed (REG-106282-18) regs published on June 18, 2019. The regulation under section 954(c)(6) only consists of cross-references to other code and reg sections. Reg. section 1.954(c)(6)-1(a)(1)–(6) is titled, “Cross-references to other rules.” It directs taxpayers to a nonexclusive list of rules that in certain cases limit the applicability of the exception to FPHCI under section 954(c)(6). These are:

An applicability date in reg. section 1.954(c)(6)-1(b) provides that this section applies as of February 23, 2020.

Section 245A. Reg. section 1.245A-5 is titled, “Limitation of section 245A deduction and section 954(c)(6) exception.” Reg. section 1.245A-5(a) provides an overview that partly describes it as providing rules that limit the applicability of section 954(c)(6) when a portion of a dividend is paid out of an extraordinary disposition account or when an extraordinary reduction occurs. Paragraph (d) provides rules that limit the application of section 954(c)(6) when one or more section 245A shareholders of a lower-tier CFC have an extraordinary disposition account. Paragraph (f) provides rules that limit the application of section 954(c)(6) when a lower-tier CFC has an extraordinary reduction amount.

Reg. section 1.245A(e)-1(c) applies to hybrid dividends of tiered corporations. It applies if a CFC (the receiving CFC) receives a tiered hybrid dividend from another CFC and a domestic corporation is a U.S. shareholder of both CFCs. In that case:

the tiered hybrid dividend is treated under section 951(a)(1)(A) as subpart F income of the receiving CFC for the tax year of the CFC in which the tiered hybrid dividend is received;
the U.S. shareholder includes in gross income its pro rata share of the subpart F income; and
the rules of section 245A(d) and reg. section 1.245A(d)-1 (disallowance of foreign tax credit and deductions) apply to the amount included in the U.S. shareholder’s gross income.

A tiered hybrid dividend is an amount received by a receiving CFC from another CFC to the extent that the amount would be a hybrid dividend under subparagraph (b)(2) if the receiving CFC were a domestic corporation. A tiered hybrid dividend does not include an amount described in section 959(b). No other amount received by a receiving CFC from another CFC is a tiered hybrid dividend.

Subparagraph (c)(3) applies if a CFC directly or indirectly sells or exchanges stock of a foreign corporation and, under section 964(e)(1), the gain recognized on the sale or exchange is included in gross income as a dividend. In that case, the rules of subparagraph (b)(3) apply by treating the CFC as the domestic corporation and include a reference to sections 964(e)(1) and 1248(c)(2) (instead of only section 1248(c)(2)).

Subparagraph (c)(4) applies to the extent that a dividend described in section 964(e)(1) (gain on certain stock sales by CFCs treated as dividends) is a tiered hybrid dividend. In that case, the rules of section 964(e)(4) do not apply to a domestic corporation that is a U.S. shareholder of both CFCs described in subparagraph (c)(1). Therefore, the U.S. shareholder is not allowed a deduction under section 245A(a) for the amount included in gross income under clause (c)(1)(ii).

Section 367. Reg. section 1.367(b)-4(e)(1) requires income inclusion and gain recognition in certain exchanges following an inversion transaction. It applies if a foreign corporation (the transferee foreign corporation) acquires stock of a foreign corporation in an exchange described in section 351 or stock or assets of a foreign corporation in a reorganization described in section 368(a)(1) (in either case, the foreign acquired corporation). In that case, an exchanging shareholder must, if its exchange is a specified exchange and the de minimis exception in subparagraph (e)(3) does not apply:

include in income as a deemed dividend the section 1248 amount attributable to the stock that it exchanges; and
after taking into account any increase in basis provided in reg. section 1.367(b)-2(e)(3)(ii) caused by the deemed dividend, recognize all realized gain that would not otherwise be recognized.

Subparagraph (e)(4) provides that an income inclusion of a foreign corporation under subparagraph (e)(1) does not qualify for the exceptions from FPHCI provided by sections 954(c)(3)(A)(i) and 954(c)(6).

Section 964. Section 964(e)(1) applies if a CFC sells or exchanges stock in any other foreign corporation. In that case, gain recognized on the sale or exchange is included in the gross income of the CFC as a dividend to the same extent that it would have been so included under section 1248(a) if the CFC were a U.S. person. Section 964(e)(4)(A) applies if, for any tax year of a CFC beginning after December 31, 2017, any amount is treated as a dividend under paragraph (e)(1) by reason of a sale or exchange by the CFC of stock in another foreign corporation held for one year or more. In that case:

the foreign-source portion of the dividend is treated as subpart F income of the selling CFC for the tax year;
a U.S. shareholder of the selling CFC must include in gross income for the tax year of the shareholder in or with which the year of the CFC ends an amount equal to the shareholder’s pro rata share of the amount treated as subpart F income; and
the deduction under section 245A(a) is allowable to the U.S. shareholder for the subpart F income included in gross income in the same manner as if the subpart F income were a dividend received by the shareholder from the selling CFC.

Section 7701. Reg. section 1.7701(l)-4(e) provides that an amount included in the gross income of a CFC as a dividend related to stock transferred in a specified transaction does not qualify for the exception from FPHCI provided by section 954(c)(6). A specified transaction is defined in reg. section 1.7701(l)-4(b).

Notice 2007-9

Notice 2007-9, 2007-1 C.B. 401, provides more general guidance on the application of section 954(c)(6). It also describes additional guidance that Treasury and the IRS intend to issue, including antiabuse rules.

According to the notice, for purposes of section 954(c)(6), a related person has the meaning provided in section 954(d)(3) and reg. section 1.954-1(f), which is ownership of more than 50 percent of vote or value. The CFCs must be related persons only at the time the dividend, interest, rent, or royalty is received or accrued. The section 954(c)(6) exception is not elective and so applies to all covered transactions.

Dividends

For purposes of section 954(c)(6), dividend has the meaning provided in section 316(a), including any amount treated as a section 301(c)(1) distribution because of a redemption described in either section 302 or 304. Dividends also include gains treated as dividends under sections 964(e) and 356(a)(2).

If a CFC is an exchanging shareholder and includes in income as a deemed dividend the full earnings and profit amount under reg. section 1.367(b)-3(b)(3)(i), that inclusion is not eligible for the section 954(c)(6) exception.

For dividends to be eligible for the section 954(c)(6) exception, the E&P of the distributing CFC need not be accumulated during a period when it was a CFC or during a period in which the CFC receiving the dividend was a related person. The key requirement is that the relevant CFCs are related persons at the time the dividend is received.

Dividends are not eligible for the section 954(c)(6) exception to the extent they are distributed out of E&P attributable to subpart F income or income that is (or is treated as) ECI. Because of the way the subpart F rules operate, distributions of earnings from a CFC to a related CFC typically will not be attributable to subpart F income. It will be attributable to E&P that either are or have been included in a U.S. shareholder’s gross income under section 951(a) (or previously taxed income). To the extent the distributions are attributable to E&P that are not PTI, it will be attributable to income that is not subpart F income. Dividends that are attributable to income that is (or is treated as) ECI are not eligible for the section 954(c)(6) exception.

Partnerships

If interest is received or accrued from a partnership with one or more partners that are CFCs, the interest will be treated as received or accrued from a CFC under section 954(c)(6) to the extent that the CFC partner would be treated as the payer of the interest under reg. section 1.954-2(b)(4)(i)(B). Similarly, if rents or royalties are received or accrued from a partnership with one or more partners that are CFCs, they will be treated as received or accrued from a CFC under section 954(c)(6) to the extent that the CFC partner would be treated as the payer under reg. section 1.954- 2(b)(5)(i)(B).

If dividends, interest, rents, or royalties are received by a partnership with one or more partners that are CFCs, those amounts will be treated as received or accrued by a CFC under section 954(c)(6) to the extent provided under reg. sections 1.702-1(a)(8)(ii), 1.952-1(g), and 1.954-1(g).

Interest

This section applies to determine the extent to which interest is attributable or properly allocable to income of the related person that is neither subpart F income nor ECI.

Allocable to Nonsubpart F Income. Interest is not eligible for the section 954(c)(6) exception to the extent the deduction for the interest payment is allocated and apportioned under section 954(b)(5) and reg. section 1.954-1(a)(4) and (c) to reduce the related CFC payer’s adjusted gross foreign base company income (as defined in reg. section 1.954-1(a)(3)), adjusted gross insurance income (as defined in reg. section 1.954-1(a)(6)), or any other category of income included in subpart F income under section 952(a).

Interest that is allocated and apportioned to income that is not subpart F income is eligible for the section 954(c)(6) exception (subject to the rules for ECI), even if interest deductions exceed the gross income of the related CFC payer in the year paid or accrued. However, interest is not eligible for the section 954(c)(6) exception to the extent interest deductions create (or increase) a deficit that under section 952(c) may reduce the subpart F income of the related CFC payer or another CFC.

Allocable to Non-ECI. Interest is not eligible for the section 954(c)(6) exception to the extent the deduction for the interest payment is allocated and apportioned under section 882(c) and reg. section 1.882-5 to gross income of the related CFC payer that is (or is treated as) ECI. It is also not eligible if, as expressly provided by or under a U.S. income tax treaty or accompanying documents (like an exchange of notes), it is allocated and apportioned to gross income of the related CFC payer that is attributable to a U.S. permanent establishment.

These interest rules apply if, in a single tax year, the related CFC payer incurs both interest expense that is eligible for the section 954(c)(6) exception (section 954(c)(6) interest expense) and other interest expense. In that case, the amount of interest expense that is treated as allocated and apportioned to ECI, or to a U.S. PE, is the related CFC payer’s interest expense for the tax year multiplied by a fraction. The numerator is equal to the amount of section 954(c)(6) interest expense, and the denominator is the related CFC payer’s total interest expense incurred during the tax year.

Interest is not eligible for the section 954(c)(6) exception to the extent interest deductions create or increase a net operating loss carryover that is ECI or attributable to a PE under a treaty.

Rents and Royalties

These rules apply to determine the extent to which rents and royalties are attributable or properly allocable to income of the related person that is neither subpart F income nor ECI.

Allocable to Nonsubpart F Income. Rents and royalties are not eligible for the section 954(c)(6) exception to the extent the deductions for the rent or royalty payments are allocated and apportioned under section 954(b)(5) and reg. section 1.954-1(a)(4) and (c) to reduce the related CFC payer’s adjusted gross foreign base company income (as defined in reg. section 1.954-1(a)(3)), adjusted gross insurance income (as defined in reg. section 1.954-1(a)(6)), or any other category of income included in subpart F income under section 952(a).

In general, rents and royalties that are allocated and apportioned to income that is not subpart F income are eligible for the section 954(c)(6) exception (subject to the rules for ECI), even if deductions for those amounts exceed the gross income of the related CFC payer in the year paid or accrued. However, rents and royalties are not eligible for the section 954(c)(6) exception to the extent deductions for those amounts create (or increase) a deficit that under section 952(c) may reduce the subpart F income of the related CFC payer or another CFC.

Allocable to Non-ECI. Rents and royalties are not eligible for the section 954(c)(6) exception to the extent the deductions for the rent or royalty payments are allocated and apportioned under section 882(c) and reg. section 1.861-8 to gross income of the related CFC payer that is (or is treated as) ECI.

Rents and royalties are not eligible for the section 954(c)(6) exception to the extent deductions for such amounts create (or increase) an NOL carryover that is ECI.

Antiabuse Rules

In addition to the general grant of regulatory authority, section 954(c)(6)(A) specifically grants the secretary the authority to prescribe regs to prevent the abuse of the purposes of section 954(c)(6). The transactions described below are abusive. However, the IRS and Treasury do not intend for this to be an exclusive list of abusive transactions and expect to provide further antiabuse rules in subsequent guidance.

Amounts That Reduce the U.S. Income Tax Base, Including Factoring Income. Transactions abuse the purposes of section 954(c)(6) if they reduce income from the U.S. income tax base by having the net effect of creating a deduction of a payment, accrual, or loss of a person subject to U.S. tax without a corresponding inclusion in the subpart F income of the CFC recipient, if the inclusion would have resulted but for section 954(c)(6).

Interest includes factoring income that is treated as income equivalent to interest under section 954(c)(1)(E) and interest described in section 864(d) (collectively, factoring income). However, certain factoring income is not eligible for the section 954(c)(6) exception. Any factoring income derived from a transaction that has the net effect of creating a deduction of a payment, accrual, or loss of a person subject to U.S. tax without a corresponding inclusion in the subpart F income of the CFC recipient, if such inclusion would have resulted in the absence of section 954(c)(6), is not eligible for the section 954(c)(6) exception. The following example illustrates the application of this paragraph.

An example in the notice assumes that domestic corporation USP owns 100 percent of the stock of CFC1 and CFC2. USP sells inventory to CFC1 in exchange for receivables. USP sells the CFC1 receivables to CFC2 at a discount, and CFC2 generates income on the collection of the CFC1 receivables.

The income earned by CFC2 on the collection of receivables is related-person factoring income as defined in section 864(d). Therefore, it is treated as interest income received on a loan from CFC2 to CFC1. However, because CFC2 acquired the CFC1 receivables from USP at a discount, causing a current loss for USP, the interest income is not eligible for the section 954(c)(6) exception.

Avoidance of Section 956. If a dividend reduces or eliminates the applicable earnings of a CFC within the meaning of section 956(b)(1) so that it reduces a U.S. shareholder’s inclusion under section 951(a)(1)(B), the dividend is not eligible for the section 954(c)(6) exception (see also reg. section 1.956-1T(b)(4)).

A second example in the notice assumes USP owns 100 percent of the stock of CFC1, which owns 100 percent of the stock of CFC2. At the beginning of year 1, when the CFC2 stock value is $300 and CFC2 has zero applicable earnings within the meaning of section 956(b)(1), CFC2 loans $100 to USP in exchange for a note. During year 1, CFC2 generates $100 of nonsubpart F E&P. Shortly before the end of year 1, CFC2 distributes $100 to CFC1, which causes a $100 dividend to CFC1. As a result, CFC2 takes the position that its applicable earnings under section 956(b)(1) are reduced from $100 to $0.

The USP note held by CFC2 is U.S. property (within the meaning of section 956(c)(1)(C)), and CFC2 generated $100 of E&P during year 1. As a result, USP would have an income inclusion of $100 under section 951(a)(1)(B) but for the applicable earnings limitation in section 956(b)(1). However, because of the year 1 dividend CFC2 paid to CFC1, CFC2 does not have any applicable earnings and USP would not have a section 951(a)(1)(B) inclusion. Therefore, the dividend income of CFC1 is not eligible for the section 954(c)(6) exception.

Use of Options or Similar Interests. Abuse occurs when the use of options or similar interests causes a foreign corporation to become a CFC payer, and a principal purpose for their use is to qualify dividends, interest, rents, or royalties paid by the foreign corporation for the section 954(c)(6) exception. In that case, the dividends, interest, rents, or royalties received or accrued from the foreign corporation will not be treated as received or accrued from a CFC payer. Therefore, they will not be eligible for the section 954(c)(6) exception. An interest that is similar to an option includes, but is not limited to, a warrant, a convertible debt instrument, an instrument other than debt that is convertible into stock, a put, a stock interest subject to risk of forfeiture, and a contract to acquire or sell stock. Published November 19, 2019, T.D. 9883 made this section of the notice obsolete with reg. section 1.954-1(f)(2)(iv)(B)(2), which contains this guidance.

Changing Character of Income Through Use of a Conduit Entity. Abuse occurs when a transaction changes the character of underlying income through the use of a conduit entity, and a principal purpose for use of the conduit entity is to qualify the underlying income for the section 954(c)(6) exception. In that case, the dividends, interest, rents, or royalties received or accrued will not be treated as received or accrued from a related CFC and, therefore, will not be eligible for the section 954(c)(6) exception.

A third example in the notice assumes USP wholly owns CFC1, a country Y corporation, and CFC2, a country Z corporation. Foreign corporation FC, also a country Z corporation, is not a CFC but is a related person under section 954(d)(3).

In year 1, FC leases property from CFC1 for $100. USP causes the rental payment to be made through CFC2. Thus, CFC2 receives a payment from FC that is excluded from FPHCI under section 954(c)(3)(A)(i). CFC2 then makes a payment to CFC1, in satisfaction of the rent owed by FC, which is intended to qualify for the section 954(c)(6) exception. A principal purpose for the involvement of CFC2 in the transaction is to qualify the rental payment from FC to CFC1 as eligible for the section 954(c)(6) exception.

If the rental payment had been made directly from FC to CFC1, it would have been included as FPHCI under section 954(c)(1)(A). By causing the payment to be made through CFC2, USP sought to convert the character of the income from FPHCI to income excluded from FPHCI. However, because a principal purpose of including CFC2 in the transaction as a conduit entity was to avoid inclusion of the rental payment from FC to CFC1 as FPHCI, it will be treated as being made from FC to CFC1. Therefore, the payment is not eligible for the section 954(c)(6) exception.

Effect of OBBBA

Washington DC, Capitol Building

getty

James C. Lawson at Baker Tilly told Tax Notes that the OBBBA permanent extension of section 954(c)(6) allows for a continuing exception to subpart F income for qualifying taxpayers. The permanent extension ensures that applicable income would remain subject to the net CFC taxable income (NCTI, formerly GILTI) rules rather than the subpart F income rules. If the look-through rule had expired as planned for taxable years of foreign corporations beginning after Dec. 31, 2025, the applicable income from related CFCs would have been subject to a higher effective tax rate under the subpart F regime for which there is no section 250 deduction that is otherwise available to corporations and individuals making a section 962 election to be taxed at corporate rates on NCTI. This permanent extension prevents a lapse in relief and ensures that the applicable income is taxable at the lower NCTI effective tax rate of 12.6 percent.

According to Lawson, limiting application of the look-through rule in the transactions cross-referenced in reg. section 1.954(c)(6)-1 is intended to prevent E&P from completely escaping inclusion when other anti-deferral regimes may not otherwise apply because of events like an ownership change.

Lawson recommends that taxpayers revisit intercompany structures that took into account the uncertainty about renewal of the rule now that a permanent extension is in place.