Treasury and IRS Finalize Targeted Guidance Addressing Section 958(b)(4) Repeal

Overview

On September 21, 2020, Treasury and the IRS released final regulations (T.D. 9908) addressing certain provisions impacted by the repeal of section 958(b)(4) in the Tax Cuts and Jobs Act (TCJA) of 2017. Specifically, the final regulations modify rules under sections 267, 332, 367, 672, 706, 863, 904, 958, and 6049 of the Internal Revenue Code (Code) that generally refer to the status of a corporation as a controlled foreign corporation (CFC) or ownership by reference to section 958(b) (i.e., taking into account constructive ownership). The final regulations follow the same general approach as the 2019 proposed regulations, with certain limited modifications, and accordingly do not address some of the most significant issues arising from the repeal of section 958(b)(4). Also on September 21, 2020, Treasury and the IRS released proposed regulations addressing two additional targeted issues arising under section 367(a) and section 954(c)(6).

Repeal of Section 958(b)(4)

TCJA repealed former section 958(b)(4), effective for the last year of a foreign corporation beginning before January 1, 2018, and taxable years of US shareholders in which or within which such foreign corporation taxable year ends. Former section 958(b)(4) prevented the downward attribution of stock ownership from foreign persons to US persons by providing that subparagraphs (A), (B), and (C) of section 318(a)(3) (providing for downward attribution to partnerships, trusts, and corporations) were not to be applied so as to consider a US person as owning stock owned by a foreign person. For example, a US corporation wholly owned by a foreign corporation would not be treated as owning the stock of the foreign parent's wholly owned foreign subsidiary.

According to the TCJA Conference Committee Report, the intent of the repeal of former section 958(b)(4) was to "render ineffective certain transactions that are used to [sic] as a means of avoiding the subpart F provisions." The Senate Finance Committee explanation also refers to "de-controlling" transactions and states that "[t]he provision is not intended to cause a foreign corporation to be treated as a controlled foreign corporation with respect to a US shareholder as a result of attribution of ownership under section 318(a)(3) to a US person that is not a related person (within the meaning of section 954(d)(3)) to such US shareholder as a result of the repeal of section 958(b)(4)." Despite statements in the legislative history indicating that the repeal was intended to only have a limited impact, section 958(b)(4) was simply stricken from the Code.

As a significant number of taxpayers have commented to Treasury, the IRS, and Congress, the repeal of section 958(b)(4) has had a much larger impact on the multinational business community, as well as for individual owners of foreign companies, private equity, and others, than apparently intended. For example, US persons directly or indirectly owning 10% or more of stock in a foreign corporation that was previously not a CFC may now have a subpart F income or GILTI inclusion attributable to the foreign corporation, which is now a CFC due to downward attribution.

The impact of the repeal of §958(b)(4) is not limited to the subpart F and GILTI regimes. There are a variety of other statutes and regulations that reference CFC status or consider ownership under section 958(b). For example, under the portfolio interest exemption of section 881(c), US source interest is not subject to the 30% gross-basis withholding tax if it meets various requirements, including that the obligation is in registered form, the recipient is not a 10% shareholder, and the interest is not received by a CFC from a related person.

Final Regulations

The final regulations released on September 21 generally take the approach of the proposed regulations issued in October 2019 by modifying rules under sections 267, 332, 367, 672, 706, 863, 904, 958, and 6049 that refer to the status of a corporation as a CFC or ownership by reference to section 958(b). The final regulations generally amend such rules to apply without applying subparagraphs (A), (B), and (C) of section 318(a)(3) so as to consider a US person as owning stock which is owned by a foreign person, i.e., without the repeal of the section 958(b)(4) limitation on downward attribution. The changes are generally intended to ensure that the operation of those regulations is consistent with their application before the repeal of section 958(b)(4).

The final regulations address the following:

Section 267(a)(2) contains a general matching rule under which a payment made to a related person that is not includible in the payee’s gross income until paid may not be deducted by the payor until the amount is included in the payee’s gross income. Under section 267(a)(3)(B)(i), an item paid to a CFC is deductible by the payor only to the extent includable in the gross income of a section 958(a) US shareholder (i.e., a US shareholder that owns stock in the CFC directly or indirectly). As a result of the repeal of section 958(b)(4), a foreign entity may be treated as a CFC but not have any US shareholders that directly or indirectly own stock under section 958(a). The final regulations provide that an amount that is income of a related foreign person is not subject to the application of section 267(a)(3)(B)(i) if the related foreign person is a CFC that does not have any US shareholders that own stock of the CFC within the meaning of section 958(a), i.e., through direct or indirect ownership.^[1] However, the CFC rule continues to apply to a CFC that has a section 958(a) shareholder even if the foreign corporation is a CFC due solely to the repeal of section 958(b)(4).
Under section 332(d)(1), a foreign corporation recognizes income from the liquidation of certain domestic holding companies by treating the liquidating distribution as a distribution under section 301. Section 332(d)(3), however, provides that exchange treatment under section 331 applies if the distributee of a distribution in complete liquidation of an applicable holding company is a CFC. With the repeal of downward attribution, the section 332(d)(3) exception could apply in situations where a foreign corporation is a CFC due to downward attribution and does not have US shareholders that would have a current income inclusion. The final regulations modify the definition of CFC under Treas. Reg. § 1.332-8 to have the meaning provided in section 957, determined without applying section 318(a)(3)(A), (B), and (C) so as to consider a US person as owning stock which is owned by a person who is not a US person.^[2]
The section 367(a) regulations contain an exception for certain transfers of stock or securities of a foreign corporation by a US transferor if the US transferor enters into a gain recognition agreement. Treas. Reg. § 1.367(a)-(8)(k)(14) provides a gain recognition agreement triggering event exception for a nonrecognition transaction if, immediately after the disposition, the US transferor meets certain requirements, including that the US transferor owns at least 5% (applying the attribution rules of section 318, as modified by section 958(b)) of the total voting power and value of the stock of such foreign corporation. To avoid the exception applying where a US transferor holds at least 5% due to downward attribution of stock owned by a foreign person, the final regulations revise this rule to apply section 958(b) without applying section 318(a)(3)(A), (B), and (C) so as to consider the US transferor as owning stock which is owned by a person who is not a US person.^[3]
Section 672(f)(1) generally provides that the grantor trust rules in sections 671 through 679 apply only to the extent they result in income being currently taken into account by a US citizen or resident or domestic corporation. Section 672(f)(3)(A) provides a special rule that, except as otherwise provided by regulations, CFCs are treated as domestic corporations for purposes of section 672(f)(1). The final regulations provide that the only CFCs taken into account for purposes of section 672(f) are those that are CFCs under section 957, determined without applying section 318(a)(3)(A), (B), and (C) so as to consider a US person as owning stock which is owned by a person who is not a US person.^[4]
Section 706 contains rules for determining the taxable year of a partnership and its partners. Under Treas. Reg. § 1.706-1(b)(6), certain interests held by foreign partners are not considered in determining the taxable year. CFCs are not treated as foreign partners for this purpose. The final regulations exclude from the definition of foreign partner only CFCs with respect to which a US shareholder owns stock within the meaning of section 958(a) (i.e., directly or indirectly) for purposes of determining a partnership taxable year.^[5]
Under section 863, space and ocean income and international communications income are sourced, in whole or in part, by the residence of the recipient. However, such income derived by a CFC may be treated as US source income, in whole or in part, in certain circumstances. The final regulations provide that CFC status for purposes of these rules is determined under section 957 but without applying section 318(a)(3)(A), (B), and (C) so as to consider a US person as owning stock which is owned by a person who is not a US person.^[6]
For purposes of assigning income to a foreign tax credit category, section 904(d)(3) provides a rule that rents and royalties received by a CFC may be treated as general category income if derived in the active conduct of a trade or business. The final regulations limit the application of this rule and certain related rules to foreign corporations that are CFCs under section 957, determined without applying section 318(a)(3)(A), (B), and (C) so as to consider a US person as owning stock which is owned by a person who is not a US person.^[7]
The regulations under Chapter 61 generally provide that the scope of payments or transactions subject to Form 1099 reporting depends, in part, on whether or not the payor is a US payor, which generally includes US persons and their foreign branches, as well as CFCs. The final regulations provide that a US payor includes a CFC under section 957, determined without applying section 318(a)(3)(A), (B), and (C) so as to consider a US person as owning stock which is owned by a person who is not a US person.^[8]
The final regulations also modify the Treas. Reg. § 1.958-2(d)(2) constructive ownership regulations to be consistent with the repeal of section 958(b)(4).^[9]

The final regulations generally apply on or after October 1, 2019. For prior taxable years, a taxpayer may generally apply the rules set forth in the final regulations to the last taxable year of a foreign corporation beginning before January 1, 2018, and each subsequent taxable year of the foreign corporation (and to taxable years of US shareholders in which or with which such taxable years of the foreign corporation end), provided that the taxpayer and related US persons apply the relevant rule consistently with respect to all foreign corporations. However, the preamble to the final regulations notes that, while Treas. Reg. § 1.958-2 (addressing constructive ownership) applies to taxable years of foreign corporations ending on or after October 1 and the associated years of US shareholders, the result in those regulations applies before such date due to the effective date of the repeal of section 958(b)(4).

The 2019 proposed regulations had also modified the definition of a CFC for purposes of section 1297(e) to disregard downward attribution from foreign persons. Under section 1297(e)(2), if a foreign corporation is a CFC and is not publicly traded, adjusted basis (rather than value) of the assets must be used when determining whether the average percentage of the corporation's assets that produce passive income is at least 50% for purposes of determining whether the foreign corporation is a passive foreign investment company (PFIC). The proposed regulations would modify the definition of a CFC for purposes of section 1297(e) to disregard downward attribution from foreign persons. The preamble to the final regulations states that Prop. Reg. §1.1297-1(d)(1)(iii)(A) will be finalized in separate PFIC-specific regulations.

In the areas described above, the relevant statutory provisions generally contain specific regulatory authority to exclude certain transactions or otherwise modify the application of the rules in certain situations, or the relevant regulatory provisions were promulgated assuming the section 958(b)(4) limitation on downward attribution and the relevant rule could operate materially differently after the repeal of section 958(b)(4). Despite the relief provided in the final regulations, there are several areas in which the apparently unintended consequences of the repeal of section 954(b)(4) remain unaddressed, both within subpart F of the Code, as well as other areas.

For example, the preamble to the final regulations mentions the portfolio interest exception of section 881(c), which excludes from its scope interest received by a CFC from a related person. The repeal of section 958(b)(4) results in foreign corporations that were previously not CFCs from being ineligible for the portfolio interest exception. The preamble to the final regulations states that "[t]he Treasury Department and the IRS have determined that there is no statutory or regulatory authority to modify the limitation on the portfolio interest exception for payments received by CFCs from a related person" or to provide exceptions to the standards of diligence applicable to withholding agents.

Proposed Regulations

On September 21, Treasury and the IRS also issued additional proposed regulations (REG-110059-20) under section 367(a) and section 954(c)(6) addressing the modification of section 958(b).

Section 367(a)(1) generally provides that if a US person transfers property to a foreign corporation in connection with an exchange described in section 332, 351, 354, 356, or 361, the foreign corporation will not be treated as a corporation for purposes of determining the extent to which gain is recognized on the transfer. Under Treas. Reg. § 1.367(a)-3(c)(1), a US person can obtain nonrecognition treatment on an outbound transfer of stock or securities of a domestic corporation (the "US target company") where the following requirements are met: (1) 50% or less of both the total voting power and the total value of the stock of the transferee foreign corporation is received in the transaction, in the aggregate, by US transferors; (2) 50% or less of each of the total voting power and the total value of the stock of the transferee foreign corporation is owned, in the aggregate, immediately after the transfer by US persons that are either officers or directors of the US target company or that are 5% target shareholders; (3) either the US person is not a 5% transferee shareholder, or the US person enters into a gain recognition agreement; and (4) the active trade or business test is satisfied. For purposes of applying these tests, Treas. Reg. § 1.367(a)-3(c)(4)(iv) states that, in general, the stock attribution rules of section 318, as modified by section 958(b), apply in determining the ownership or receipt of stock, securities, or other property. Thus, the repeal of section 958(b)(4) and the resulting application of section 318(a)(3)(A), (B), and (C) to the stock ownership tests under Treas, Reg. § 1.367(a)-3(c)(1) can cause a transfer that previously would have satisfied the conditions in Treas. Reg. § 1.367(a)-3(c)(1) to no longer qualify for the exception to section 367(a)(1) because, for example, more shareholders are now considered to be 5% target shareholders as a result of downward attribution. Under the proposed regulations, for purposes of applying Treas. § 1.367(a)-3(c)(1)(i), (ii), and (iv), a US person’s constructive ownership interest does not include an interest that is treated as owned as a result of downward attribution from a foreign person.^[10] However, for purposes of the condition set forth in Treas. § 1.367(a)-3(c)(1)(iii) (which requires that either the US person is not a 5% transferee shareholder or the US person must enter into a gain recognition agreement), the constructive ownership rules will continue to take into account downward attribution. These changes are proposed to apply to transfers occurring on or after September 21, 2020, though taxpayers may apply the rules to transfers occurring in years the repeal of §954(b)(4) is effective provided that the taxpayer and related parties provide the changes consistently.^[11]

The 2020 proposed regulations also make changes in connection with section 954(c)(6), which generally provides that dividends, interest, rents, and royalties received or accrued by a CFC from a CFC that is a related person are not treated as foreign personal holding company income to the extent attributable or properly allocable to income of the related person that is neither subpart F income nor effectively connected income. The proposed regulations address a situation in which a CFC (without regard to downward attribution) is a member of a group with a foreign parent and receives a payment potentially covered by section 954(c)(6) from a foreign subsidiary of the parent that is treated as a CFC solely by reason of downward attribution. In such situation, the payment received by the first CFC may be eligible for the exception under section 954(c)(6) even though the income of the second CFC is not taxed by the United States because the second CFC has no direct or indirect US shareholders. To address this situation, the proposed regulations provide that, for purposes of section 954(c)(6), the term CFC has the meaning given by section 957, determined without applying section 318(a)(3)(A), (B), and (C) so as to consider a US person as owning stock which is owned by a person who is not a US person.^[12] These changes are proposed to be effective to payments or accruals of dividends, interest, rents, and royalties made by a foreign corporation during taxable years of the foreign corporation ending on or after September 21 (and taxable years of US shareholders in which or with which such taxable years of the foreign corporation end) as well as such taxable years ending before September 21, 2020, resulting from an entity classification election or change in taxable year under section 898 that was effective on or before September 21 but filed on or after September 21.^[13]

Prior Relief

Treasury and the IRS have also provided additional guidance related to the repeal of former section 958(b)(4) in Revenue Procedure 2019-40. The regulations issued on September 21 do not impact this relief.

Generally, Revenue Procedure 2019-40 sets out three safe harbors for taxpayers impacted by the repeal of former section 958(b)(4) and announces that penalties under section 6038 (failure to furnish information) and section 6662 (underpayment) will not be applied if taxpayers satisfy certain requirements. The first safe harbor applies to the determination of whether a foreign corporation is a CFC. The second safe harbor applies to the determination of taxable income and the earnings and profits of a CFC and allows certain US shareholders to use specified alternative information in making those determinations. The third safe harbor concerns using alternative information for determining section 965 amounts.

Legislative Proposals

Despite Treasury and the IRS’s efforts to address certain unintended consequences of the repeal of section 958(b)(4), many issues remain and may not be ameliorated without action by Congress. There have been legislative proposals to restore section 958(b)(4) while addressing the decontrolling transactions that motivated its repeal. For example, in March 2020, a version of the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act) would have restored section 958(b)(4) to its pre-TCJA wording while enacting new section 951B.^[14] Similar proposals are likely to emerge in future legislation.

Proposed section 951B (Amounts Included in Gross Income of Foreign Controlled United States Shareholders) would create the new categories of "foreign controlled United States shareholder" and "foreign controlled foreign corporation" and extend the application of the subpart F income, GILTI, and section 965 regimes to foreign controlled United States shareholders of foreign controlled foreign corporations. For this purpose, a foreign controlled US shareholder means any US person who would be a US shareholder with respect to a particular foreign corporation if the restored section 958(b)(4) were not applied (i.e., no limitation on downward attribution exists) and by applying the section 951(b) definition of US shareholder with a more than 50% threshold rather than a more than 10% threshold. A foreign controlled foreign corporation means any non-CFC that would be a CFC if section 957(a) were applied by considering foreign controlled United States shareholders instead of US shareholders and by applying section 958(b) without reference to the (restored) section 958(b)(4), i.e., without the limitation on downward attribution. Proposed section 951B would apply retroactively to the last taxable year of foreign corporations beginning before January 1, 2018, and each subsequent taxable year of such foreign corporations, and taxable years of United States persons in which or with which such taxable years of foreign corporations end.

[1] Treas. Reg. § 1.267(a)-3(c)(4).

[2] Treas. Reg. § 1.332-8(a).

[3] Treas. Reg. § 1.367(a)-8(k)(14)(ii).

[4] Treas. Reg. § 1.672(f)-2(a).

[5] Treas. Reg. § 1.706-1(b)(6)(ii).

[6] Treas. Reg. § 1.863-8(b)(2)(ii); §1.863-9(b)(2)(ii).

[7] Treas. Reg. § 1.904-5(a)(4)(i).

[8] Treas. Reg. § 1.6049-5(c)(5)(i)(C).

[9] Treas. Reg. § 1.958-2.

[10] Prop. Treas. Reg. § 1.367(a)-3(c)(4)(iv).

[11] Prop. Treas. Reg. § 1.367(a)-3(c)(11)(ii).

[12] Prop. Treas. Reg. § 1.954(c)(6)-2(a).

[13] Prop. Treas. Reg. § 1.954(c)(6)-2(b)(1).

[14] § 2209, S. 3548, 116th Cong.; see also S. 2589, 116th Cong.; H.R. 4509, 116th Cong.