December 21, 2022
Proposed regulation could increase 2022 income for certain consolidated groups
On December 9, 2022, Treasury and the IRS released a proposed regulation (REG-113839-22) that, if finalized, would treat members of a consolidated group as a single US shareholder with respect to a particular CFC for the limited purpose of calculating the members' pro rata share of the CFC's subpart F income or GILTI tested items. The proposed regulation would prevent members of a consolidated group from applying IRC Section 951(a)(2)(B) to reduce the pro rata share of a US shareholder in a tax year in which the CFC distributed PTEP to another CFC. If Treasury meets its goal, as reported in the tax press,1 of publishing the final regulation in the Federal Register before April 15, 2023, the proposed regulation would apply to the 2022 tax year of consolidated groups with a calendar tax year.
Only certain US shareholders of a foreign corporation (i.e., inclusion shareholders) must include in gross income amounts determined with reference to the corporation's subpart F income and GILTI tested items (including tested income) for a given tax year. To be an inclusion shareholder, the US shareholder must own, within the meaning of IRC Section 958(a) (Section 958(a) ownership), shares of CFC stock (Section 958(a) shares) on the last day of the corporation's tax year on which the corporation constitutes a CFC (inclusion date). An inclusion shareholder includes in gross income the pro rata share (a term of art) of the CFC's subpart F income and GILTI tested items determined with respect to the Section 958(a) shares that the shareholder owns on the inclusion date (the shareholder's inclusion shares).
To prevent an inclusion shareholder from being taxed twice on the same CFC income, a CFC's distribution of PTEP — i.e., earnings and profits (E&P) associated with income on which the inclusion shareholder previously paid tax — generally is not taxable to an inclusion shareholder. Under IRC Section 959(a), an inclusion shareholder's (or a successor's) receipt of a PTEP distribution from a CFC (a Section 959(a) distribution) generally does not increase the shareholder's gross income. Similarly, IRC Section 959(b) generally does not treat the receipt by one CFC (an upper-tier CFC) of a PTEP distribution from another CFC (a lower-tier CFC) as subpart F income to the upper-tier CFC if the two CFCs are in a chain of Section 958(a) ownership (a Section 959(b) distribution).
IRC Section 951(a)(2) governs the computation of a U.S. shareholder's pro rata share with respect to its inclusion shares. In many cases, an inclusion shareholder's pro rata share of a CFC's subpart F income (for example) for a particular tax year is simply the amount that the US shareholder would have received with respect to the shareholder's inclusion shares if, on the corporation's inclusion date for that year, the corporation had distributed an amount with respect to its inclusion shares equal to its subpart F income in that year.
In certain circumstances, however, an inclusion shareholder's "hypothetical distribution" amount (and thus its pro rata share) is reduced. Section 951(a)(2)(B) describes one reduction. It applies when, during the CFC's particular tax year, a person other than the inclusion shareholder received a dividend on the inclusion shares. In that circumstance, the Section 951(a)(2)(B) reduction to the inclusion shareholder's pro rata share generally is the lesser of two amounts.
The first is the amount of the dividend received by that "other" person (the Section 951(a)(2)(B) dividend). A dividend generally is a distribution by a corporation with respect to its stock from the corporation's E&P.
The second amount is the portion of the corporation's subpart F income and tested income for its tax year that is proportional to the period of that year during which the inclusion shareholder was not the Section 958(a) owner of the inclusion shares. This means that IRC Section 951(a)(2)(B) will only reduce an inclusion shareholder's pro rata share if the inclusion shareholder did not own the inclusion shares for some period during the corporation's tax year (the Section 958(a) ownership condition for a Section 951(a)(2)(B) reduction).
Due to how Section 958(a) ownership is defined, as to each share of a CFC's stock, only one member of a consolidated group can be the Section 958(a) owner of that share on the inclusion date (as to that share, the inclusion member). Just as in a standalone case, the inclusion member with respect to a share of stock must include the pro rata share of the corporation's subpart F income and GILTI tested items for that share.
When there is a shift in Section 958(a) ownership of CFC stock between members of a consolidated group during the CFC's tax year, absent adjustments under the consolidated return regulations, the inclusion member's ownership period does not include that of the other member. Thus, the other member's ownership period satisfies the Section 958(a) ownership condition for a Section 951(a)(2)(B) reduction to the inclusion member's pro rata share. However, where the intragroup shift in Section 958(a) ownership occurs directly or indirectly through an intercompany transaction (i.e., a transfer of CFC stock from one member of the consolidated group to another), additional uncertainties arise from the application of Reg. Section 1.1502-13 to such a transaction. While the proposed regulation does not address these issues, Treasury and the IRS do invite comments on the topic.
The proposed regulation released on December 9 (Prop. Reg. Section 1.1502-80(j)) would apply to a consolidated group in very limited circumstances:
The proposed regulation would treat all of the members of the consolidated group as a single US shareholder for purposes of computing the Section 951(a)(2)(B) reduction. As such, there would be no period during the CFC's tax year during which that single US shareholder would not have been the Section 958(a) owner of the inclusion shares. By reason of the Section 958(a) ownership condition to the Section 951(a)(2)(B) reduction, then, there would be no Section 951(a)(2)(B) reduction to the inclusion member's pro rata share. Treasury and the IRS believe that the proposed regulation is necessary to "facilitate the clear reflection of income of a consolidated group" by mooting the effect of shifts in Section 958(a) ownership of inclusion shares of a foreign corporation among group members.
The proposed regulation includes two examples. In Example 1, M1 and M2 are members of a consolidated group. At the beginning of Year 2, M1 directly owns all of the stock of CFC1, which in turn owns all of the stock of CFC2. CFC2's E&P includes $100 of PTEP attributable to an inclusion of subpart F income by M1 in Year 1. All of the entities have a calendar tax year.
In Year 2, CFC2 earns $80 of subpart F income and makes a Section 959(b) distribution of $80x to CFC1 (sourced from CFC2's Year 1 PTEP). On December 29, Year 2, M1 transfers all of its CFC1 stock to M2 in an IRC Section 351 exchange. As a result, on the inclusion date of CFC2's Year 2 tax year (December 31, Year 2), M2 is the inclusion member for all of CFC2's stock. M2's pro rata share of CFC2's subpart F income would be $80, subject to reduction under IRC Section 951(a)(2)(B).
Although M1 (not M2) was, for general purposes, the Section 958(a) owner of CFC2's inclusion shares for 363 days during CFC's 365-day Year 2 tax year, the example concludes that the Section 951(a)(2)(B) reduction to M2's pro rata share is zero. Applying Prop. Reg. 1.1502-80(j)(1) to determine the period in Year 2 during which M2 was not the Section 958(a) owner of the inclusion shares, M1, M2, and the other members of their consolidated group are treated as a single US shareholder. Accordingly, that single US shareholder is the Section 958(a) owner of CFC2's shares on every day during its Year 2 tax year. Due to the Section 958(a) ownership condition, the Section 951(a)(2)(B) reduction is zero. M2's pro rata share of CFC2's $80 of subpart F income in Year 2 is $80.
If finalized as proposed, Prop. Reg. Section 1.1502-80(j)(1) would apply to a tax year of a consolidated group if the due date for filing the group's original income tax return for that year (without extensions) were after the date on which the final regulation is published in the Federal Register. It has been reported in the tax press that a Treasury official publicly confirmed on December 15, 2023, that Treasury is seeking to publish the final regulation before April 15, 2023.2 If Treasury and the IRS succeed in doing so, the final regulation would apply to tax years of consolidated groups ending on or after December 31, 2022.
Prop. Reg. Section 1.1502-80(j)(1) is apparently intended to preclude consolidated taxpayers from taking the position that a Section 959(b) distribution by a CFC, coupled with a shift in the Section 958(a) ownership of the CFC's stock among consolidated group members, results in the inclusion of less of the CFC's subpart F income and GILTI tested items in consolidated gross income. The scope of the proposed regulation is therefore quite limited.
Because of the uncommon effective date for Prop. Reg. Section 1.1502-80(j), which is based on the due date (without extensions) of the consolidated group's return, the proposed regulation would effectively be retroactive and could affect transactions completed before the proposed regulations were first introduced. To this end, a Treasury official reportedly has confirmed that Treasury will attempt to publish the regulation as final before April 15, 2023.3 If this happens, taxpayers that have a calendar tax year and carried out transactions during 2022 that fall within the regulation's scope may be required to include more in consolidated gross income than they had anticipated.
Lastly, Treasury and IRS also indicated that they are further considering the interactions of IRC Sections 951(a)(2)(B) and 959(b), so any additional guidance under those sections, including guidance to prevent abuse, may be retroactive.
Published by NTD’s Tax Technical Knowledge Services group; Maureen Sanelli, legal editor
1 Andrew Velarde, Treasury Wants Final Consolidated CFC Income Regs by April 2023, Tax Notes Today (Dec. 16, 2022).