Section 956 Inclusions:New Limit on Foreign Taxes Deemed Paid

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By Lowell D. Yoder, Esq.

McDermott Will & Emery LLP, Chicago, IL 

Congress recently enacted §960(c), which limits the amount of foreign tax credits that accompany a Subpart F inclusion resulting from an investment in U.S. property. This is achieved by modifying the application of the so-called "hopscotch rule."1 

By way of background, §951(a)(1)(A) requires U.S. shareholders of a controlled foreign corporation (CFC) to include in their gross incomes their pro rata shares of the Subpart F income of the CFC. Subpart F income includes passive income (e.g., interest, dividends, royalties, and capital gains) and certain sales and services income.2  In addition, §951(a)(1)(B) requires U.S. shareholders of a CFC to include in their gross incomes their pro rata shares of the amounts determined under §956 resulting from investments by the CFC in U.S. property. Such investments include tangible property located in the United States, and stock and obligations of related U.S. persons.3 

These inclusion rules apply to first-tier as well as lower-tier CFCs. For example, assume that a U.S. parent (USP) owns all of the stock of CFC1, organized in Country A, which in turn owns all of the stock of CFC2, organized in Country B. CFC2 has $100 of Subpart F income. USP must include in its gross income the $100 of CFC2's Subpart F income. The earnings of a lower-tier CFC that are currently taxable to U.S. shareholders under §951(a) are deemed distributed directly to them, i.e., the deemed "dividend" hops over intervening CFCs (the hopscotch rule).

Section 960, by reference to §902, provides a deemed-paid tax credit for a corporate U.S. shareholder with respect to foreign taxes paid on amounts included in its gross income under §951(a).  Under §902, a corporate shareholder that receives a dividend from a foreign corporation may claim a tax credit for foreign income taxes paid by the foreign corporation on the earnings distributed, provided that the corporate shareholder owns 10% or more of the voting stock in the foreign corporation.4  Section 960 generally incorporates by reference the rules contained in §902, treating the Subpart F inclusions as dividends.  The U.S. shareholder must gross up the amount of the dividend or Subpart F inclusion by the amount of the deemed-paid foreign income taxes.5 

The amount of deemed-paid foreign income taxes that accompany a dividend or Subpart F inclusion is calculated based on multi-year pools of earnings and taxes. A shareholder is deemed to have paid the same proportion of a foreign corporation's post-1986 foreign income taxes as the amount of the dividend or Subpart F inclusion bears to such foreign corporation's post-1986 undistributed earnings.  This calculation is made on the basis of separate limitation categories, i.e., the passive category and general category.

A dividend received by a higher-tier CFC from a lower-tier CFC is added to the earnings pool of the higher-tier CFC. Such dividend brings foreign income taxes in an amount that would be deemed paid by a U.S. shareholder if the dividend were distributed to a U.S. shareholder, which are added to the taxes pool of the higher-tier CFC.6  The amount of deemed credits that accompany a further distribution of the earnings to the U.S. shareholder is determined on the basis of the upper-tier CFC's earnings and taxes pools, which would include the dividend received from the lower-tier CFC and accompanying foreign taxes.Example 1. Assume the above ownership structure. CFC1 has post-1986 undistributed earnings of 900u (assume 1u equals $1) and post-1986 foreign income taxes in the amount of $100 (i.e., an effective tax rate of 10%). CFC2 has post-1986 undistributed earnings of 600u and post-1986 foreign income taxes of $400 (i.e., an effective tax rate of 40%). Assume that CFC2 distributes 300u to CFC1, and CFC1 in turn distributes 300u to USP. The distribution by CFC2 to CFC1 would increase the post-1986 undistributed earnings of CFC1 from 900u to 1,200u. The CFC2 distribution would bring $200 of foreign income taxes (i.e., 300u/600u × $400) and therefore increase CFC1's post-1986 foreign income taxes pool from $100 to $300.  The 300u distributed by CFC1 to USP would result in a deemed-paid tax credit of $50 (300u/1,200u × $300). USP would include the $300 in income as well as an additional $50 for the gross-up amount.  The dividend would have an effective tax rate of approximately 14% ($50/$350), and USP would pay $72.5 of U.S. taxes on the distribution. 

The result would be the same if the dividend received by CFC1 from CFC2 were Subpart F income included in the gross income of USP (following the expiration of the look-through rule of §954(c)(6)).

In contrast, the hopscotch rule generally applies for purposes of calculating the deemed-paid taxes associated with Subpart F inclusions from lower-tier CFCs. The amount is not considered distributed up through the upper-tier CFCs but is deemed distributed directly to the U.S. shareholders.7  Section 960(a)(1) provides that the deemed-paid taxes that accompany the inclusion are calculated based on only the lower-tier CFC's earnings and profits and taxes pools.8  Example 2. Assume the facts of Example 1 without the dividend distributions. CFC2 makes a loan to USP that constitutes an investment in U.S. property resulting in a §951(a)(1)(B) inclusion in the amount of 300u. The inclusion is deemed distributed directly by CFC2 to USP. Prior to §960(c) (discussed below) becoming effective, the amount of the deemed-paid taxes accompanying the inclusion would be $200 (300u/600u × $400). Accordingly, the effective tax rate on the deemed dividend would be 40% and there generally should be no incremental U.S. tax. 

Under the hopscotch rule, the deemed-paid tax calculation is made based only on the earnings and profits and taxes pools of CFC2. The earnings and profits and taxes pools of CFC1 are not relevant because the inclusion of the amount in USP's gross income is considered as occurring directly from CFC2.

The new legislation adds §960(c), limiting the amount of foreign income taxes that accompany an inclusion under §951(a)(1)(B) for investments in U.S. property. The limitation is determined by calculating a U.S. shareholder's deemed-paid foreign tax credits as if cash in an amount equal to the amount of the §951(a)(1)(B) inclusion were distributed in a series of distributions through the chain of ownership which begins with such CFC and ends with the U.S. shareholder ("hypothetical credit"). If this amount is less than the taxes deemed paid by the U.S. shareholder without regard to the new rule (the "tentative credit"), then the amount of the U.S. shareholder's credit is the hypothetical credit.9  Example 3. Under the facts of the above example, the hypothetical credit is calculated as if the 300u were distributed by CFC2 to CFC1, and then by CFC1 to USP. This would result in an amount of deemed-paid taxes of $50, as calculated in Example 1 involving a dividend paid up through the chain to USP. Because the $50 hypothetical credit is less than the $200 tentative credit, USP's foreign tax credit with respect to the 300u included in its gross income pursuant to §951(a)(1)(B) would be limited to $50.  The result apparently would be the same if the 300u received by CFC1 from CFC2 were Subpart F income (after §954(c)(6) expires).

After the inclusion, CFC2 would have 300u of previously tax income, 300u of undistributed earnings, and $350 post-1986 foreign income taxes.10  

Any withholding taxes that countries A and B might have imposed on a distribution up through the chain of ownership would not be taken into account. If withholding taxes are imposed when the previously taxed income is subsequently distributed, such taxes will accompany the distribution.11 

If the hypothetical credit exceeds the tentative credit, then the deemed-paid credit is the tentative credit. For example, if CFC1 had $800 of taxes associated with its 900u of earnings, the hypothetical credit would be $250 (300u/1,200u × $1,000).  Under these facts, the new rule would not apply and the foreign income taxes deemed paid with respect to the §951(a)(1)(B) inclusion should be $200 (i.e., the tentative credit). If a taxpayer desires to increase its foreign tax credits, the 300u can instead be distributed to USP through CFC1, thus bringing back the greater amount of deemed-paid foreign income taxes.

Neither §960(c) nor the legislative history expressly addresses the result if CFC1 had previously taxed income (PTI). For example, if in Example 3 CFC1 had 300u of PTI, a deemed distribution by CFC1 to USP would be a non-taxable distribution of PTI, and would generally bring no deemed-paid foreign tax credits, i.e., a hypothetical credit of zero. This result would appear to lead to an inappropriate separation of taxes from the 300u of earnings that are included in the income of USP.12 

The Joint Committee on Taxation Technical Explanation ("JCT Explanation") provides an example of CFC2 having 325u of PTI (numbers are modified to fit the example used herein).  Where CFC2 has a 300u investment in U.S. property, there would be no deemed distribution under §951(a)(1)(B). The JCT Explanation states that the excess taxes remaining at CFC2 would be $400 "because the applicable ordering rules would prioritize the hypothetical distribution as coming first from the [325u] in previously taxed income over the [275u] of untaxed earnings." However, in this case §956 would not result in a deemed inclusion because of the PTI, i.e., the amount of PTI reduces the amount of the investment in U.S. property to zero. Therefore, the hypothetical computation should not even apply.

This new rule can be particularly detrimental if an upper-tier CFC has a large deficit in earnings and profits.Example 4. Assume the facts in Example 3, except that CFC1 has a 400u deficit in its general limitation pool (before taking into account dividend income). The hypothetical credit is calculated as if the 300u were distributed by CFC2 to CFC1, and then by CFC1 to USP. This would result in a hypothetical credit of zero, because no deemed-paid taxes accompany CFC1's deemed 300u dividend since CFC1 has a deficit in its general limitation pool [300u + (400u) = (100u)].13 

Prior to the new rule, the above adverse foreign tax credit result could be avoided if the 300u of CFC2's earnings were deemed distributed directly to USP under the hopscotch rule.14  Under the new rule, foreign tax credits would accompany the §951(a)(1)(B) amount only if CFC2's investment in U.S. property exceeded the amount of CFC1's deficit.

The JCT Explanation describes the result where CFC1 has 200u of earnings with $10 of taxes and CFC2 has $100 of earnings with $50 of taxes. CFC1 distributes to USP all of its 200u of earnings and CFC2 has a §951(a)(1)(B) inclusion of its 100u of earnings during the same year. The CFC1 dividend is accompanied with $10 of foreign income taxes. The JCT Explanation indicates that the hypothetical credit with respect to the §951(a)(1)(B) inclusion would be $20 (100u/300u × $60), effectively ignoring CFC1's dividend. This result would appear to be computationally incorrect, in that the entire 300u of earnings of CFC1 and CFC2 would have been included in the income of USP, but $30 of taxes associated with such earnings would not be available as a credit. It seems obvious that the rules should be applied in a manner that causes all of the foreign taxes associated with the taxable earnings to accompany the earnings.15 

The hopscotch rule would continue to apply for purposes of determining the amount of the inclusion. For example, if in the earlier examples the amount of CFC2's earnings were 200u rather than 600u, the amount of the §951(a)(1)(B) inclusion would be the 200u of CFC2's earnings (even if the amount of the investment were 300u). The earnings of CFC1 would not be taken into account for this purpose.

In addition, the new rule does not apply to inclusions of Subpart F income under §951(a)(1)(A). For example, if CFC2 received a dividend from a lower-tier subsidiary, CFC3, that is Subpart F income, such dividend would be deemed distributed directly to USP for purposes of calculating the deemed-paid tax credits (i.e., the new §960(c) limitation would not apply).16 

The new rule would not impede the use of §956 to access low-taxed earnings of lower-tier CFCs to absorb expiring foreign tax credits.17  For example, assume that CFC2's effective tax rate was only 2%. An investment in U.S. property made by CFC2 would only bring credits from CFC2 at the 2% rate.

The new rules would not have any impact on the affirmative use of §956 for first-tier CFCs (including a CFC owned by a disregarded foreign entity that is owned by a U.S. shareholder).  Accordingly, §956 may be affirmatively used by such CFCs to minimize withholding taxes or avoid legal restrictions on the ability to distribute dividends while triggering deemed-paid credits.18  Similarly, the new rule also would not impact the determination of foreign tax credits where a second-tier CFC is owned by a first-tier CFC that does not have any earnings and profits.

Overall, this new rule is somewhat perplexing.  The hopscotch rule allows the taxes associated with the particular earnings of a lower-tier CFC to accompany the corresponding earnings, which is consistent with the fundamental policy of the foreign tax credit provisions and the other recently enacted foreign tax credit rules (e.g., §909). Such a rule provides flexibility in organizing foreign operations to accommodate business needs (e.g., using holding companies). The perceived "loop-hole" closing benefits do not seem to warrant the additional complexity. Indeed, the rule can be overreaching in that earnings can be subject to U.S. taxation without a credit for foreign taxes paid on such earnings. 

This commentary also will appear in the December 2010 issue of the Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Madole, 929 T.M., Controlled Foreign Corporations — Section 956,  and in Tax Practice Series, see ¶7150, U.S. Persons—Worldwide Taxation.


1 P.L. 111-226; see Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the Senate Amendment to the House Amendment to the Senate Amendment to H.R. 1586, Scheduled For Consideration by the House of Representatives on August 10, 2010(JCX-46-10) (8/10/10), pp. 20-26 ("JCT Explanation").  

2 §§952(a), 954. 

3 §956(c). 

4 §§901(a), 902(a). 

5 §78; Regs. §1.960-3(a).   

6 §902(b). 

7 SeeYoder, "Subpart F Hopscotch Rule Permits Targeted Repatriation," 32 Tax Mgmt. Int'l J. 317 (6/13/03); Yoder, "Subpart F Repatriation: Distribution Timing is Everything," 32 Tax Mgmt. Int'l J. 427 (8/8/03). 

8 A corporate shareholder is entitled to deemed-paid tax credits with respect to Subpart F inclusions from lower-tier CFCs that are part of a qualified group. Among other things, a lower-tier CFC is a member of a qualified group if there is 10% ownership between each CFC, and the U.S. shareholder indirectly owns at least 5% of the CFC. In addition, a credit is provided only for foreign taxes paid by first- through sixth-tier CFCs. §902(b)(2).   

9 The new rule is effective for acquisitions of U.S. property after Dec. 31, 2010. Accordingly, it does not apply to U.S. property acquired on or before such date.  A loan made to a U.S. parent on or before Dec. 31, 2010, would not be subject to this provision unless there was a significant modification of the debt instrument pursuant to Regs. §1.1001-3. 

10 CFC2 would need to distribute the 300u of PTI before any deemed-paid taxes would accompany a distribution. 

11 §960(a)(3), Regs. §§1.960-2(e), 1.904-6(c), Ex. 7.  

12 If instead the deemed dividend from CFC2 to CFC1 were Subpart F income to CFC1 (e.g., after §954(c)(6) expires), such amount should be includible in the income of USP regardless of CFC1's PTI, and accordingly should result in a hypothetical foreign tax credit.  

13 Regs. §1.902-1(b)(4).  The result would be the same if the 300u were instead considered Subpart F income to CFC1. The Subpart F high-tax exception would be unavailable because no §960 deemed-paid foreign taxes accompany the deemed Subpart F amount included in USP's income.  

14 SeeRegs. §1.902-1(f), Ex. 4 (suggests this solution under similar facts). 

15 It would be disingenuous for §960(c) to be applied in a manner such that earnings are subject to U.S. taxation but taxes associated with the earnings are not available as a credit, given that a "matching" rule in the same legislation would deny a credit for foreign taxes until the earnings are subject to taxation.  

16 Section 304 and "cash D" transactions also can result in earnings of a lower-tier CFC being treated as distributed directly from the lower-tier CFC to USP. See Yoder, "International Planning Using Code Sec. 304(a)(1)," 33 Int'l Tax J. 3 (2007); Yoder, "CFC Purchase of Stock in a Related CFC: Code Sec. 304 v. D Reorganization Treatment," 35 Int'l Tax J. 3 (2008).  

17 The new rule presupposes that taxpayers may affirmatively trigger an inclusion under §951(a)(1)(B). See Rev. Rul. 90-112, 1990-2 C.B. 186; Regs. §1.902-1(f), Ex. 4; PLR 8912037 (12/23/88); PLR 8114032 (12/30/80); FSA 961121; FSA 950823. See alsoNotice 2008-91 (making expanded short-term obligation exception elective, presumably to accommodate affirmative use of §956); 1986 TRA Blue Book, at 1085-86, 1089-90; Amstead Industries, Inc. v. Comr., Doc. No. 47616-86, discussed in Tax Notes Int'l (July 1989), at 72. 

18 See Yoder, "Tax Court Applies Penalties to Routine Foreign Tax Credit Planning Transaction," 4 J. of Tax'n of Global Trans. 3 (Spring 2004).