Most international tax professionals and the IRS believe Congress made a mistake (“The Mistake”) when they repealed Sec. 954(b)(4) in the 2017 TCJA Act, thinking they were punishing certain expatriated US companies when in fact they brought into US taxation a number of foreign corporations that are clearly not controlled by US Shareholders.
Even if it did not create additional US taxation (which it did in many cases) the rule created massive compliance burdens that result in penalties of $10,000 for each “new” foreign corporation that is now a controlled foreign corporation (CFC) and a US Shareholder fails to file a Form 5471 with its tax return. This impacts both US individuals and corporate taxpayers.
The Mistake has resulted in a number of additional CFCs because of downward attribution of ownership. Certain US corporations that are owned and controlled by a foreign parent company can now be US Shareholders of the parent company’s other foreign subsidiaries and must report on these subsidiaries as CFCs (Form 5471). Any other US Shareholder that might be minority owners in the structure and were not previously required to report or have any deemed taxable income from these new CFCs must now also report.
However, depending upon the provision, the regulations actually turn off the downward attribution rule and treat the CFC as not being one (pre-TCJA rule). This can result in the following situations:
- Unintended consequences of the related party rules (Sec. 267(a)(2)) for determining the time at which an otherwise deduction amount owned to a foreign related party may be deducted. This can impact the timing of interest expense deductions.
- Prevents taxpayers from using a CFC with no US Shareholders to take advantage of the special rules for CFC grantors of trust that facilitate tax-free distributions from the trust to US Beneficiaries of the trust, despite no income inclusion by the CFC Shareholders.
- Prevents use of an exception to avoid US tax on a liquidating distribution to a corporate shareholder under Sec. 332(d)(3).
- Prevent a gain recognition (GRA) triggering event exception from applying to a US transferor that otherwise would have been eligible under the downward attribution rules.
- Prevent application of the affiliated group rules in the FTC active rents and royalties exception, as well as the CFC look-through rule, to foreign corporations that are CFC without regard to the downward attribution from foreign persons. This would effectively put these payments into the passive basket.
- Prevent application of the downward attributions rules when determining if a CFC is treated as a US payor for Form 1099 reporting purposes.
The proposed regulation under these provisions also moved a PFIC provision to those July 2019 proposed regulations. They proposed to preclude a foreign corporation that became a CFC solely under the downward attribution rules from using adjusted basis to measure assets under the PFIC asset test (Sec. 1297(e)). This is apparently to force the use of the FMV test (unless elected out) and mainly appears to be of little consequence since CFC are no longer PFIC by definition.
Modifications to Rules for Deducting Foreign Related Payments and CFC Look-Through Rules
These two provisions may have the most impact for many US taxpayers. The first of these two items is under the final regulations while the second has an FTC impact (final regulations) and a Subpart F impact (proposed regulations).
Deduction of Payments (Foreign Payor/Payee Rule)
With respect to payments to CFC, a deduction is allowed to the payor for any tax year before the year in which the payment is made only to the extent that an amount attributable to the item is includable during the prior tax year in the gross income of a US person who owns stock in the CFC, directly or indirectly through foreign entities.
An exception to the CFC payee rules in the proposed regulations is expanded to cover all amounts payable to a related foreign person that is a CFC that does not have a direct or indirect US Shareholder. The foreign payee rules will apply to those payments exempt from the application of the CFC payee rule. However, the CFC payee rules continues to apply to a CFC that has a direct or indirect shareholder, even if the foreign corporation is a CFC due solely to the downward attribution rule. So, US Shareholder that would receive deemed income (GILTI or Subpart F) can still use the CFC payee rule.
CFC Look-Through Rule-Subpart F
The Subpart F impact of the second item in this section applies to foreign personal holding company items (dividends, interest, rents and royalties) between related CFCs. The proposed regulations limit the application of this exception to amounts from CFC that are not CFC because of the downward attribution rules (the pre-TCJA rules). These proposed regulations are to apply to payments or accruals made by a foreign corporation during tax years of the foreign corporation ending on or after September 21, 2020 (so all of 2020 calendar year foreign corporations-effective now). Once finalized, taxpayers may apply to calendar year 2017 foreign corporation (or rely on these proposed regulations).
If you need assistance navigating these complex rules, contact us.
James J. Miesowicz, CPA
Gus Sinclair, Co-Author