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By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL
The ordering rules that govern the U.S. taxation of dividends and Subpart F inclusions from a controlled foreign corporation (CFC) are not intuitive and can produce surprising results. The rules also are not easily discernable from the Code or regulations, and certain ordering rules in the regulations are inaccurate because they have not been updated to reflect legislative amendments.1
As background, the income of a foreign subsidiary generally is not subject to U.S. taxation. A CFC's earnings and profits (sometimes referred to herein simply as "earnings") are included in the gross income of its U.S. shareholders when there are actual distributions (but only to the extent of the earnings) or when there are deemed distributions under "Subpart F." Under Subpart F, earnings of a CFC are included in the income of the U.S. shareholders to the extent the CFC has Subpart F income or is considered to invest its earnings in U.S. property.2
Such Subpart F inclusions are an accelerated taxation of a CFC's earnings that would otherwise be taxable when actual distributions are made. Accordingly, the earnings and profits of the foreign subsidiary serve as a limitation on the amounts included in income under Subpart F. Furthermore, earnings that are subject to taxation under Subpart F as a deemed dividend are not taxed again when actual distributions are made to the U.S. shareholders.
In determining the U.S. taxation of a CFC's earnings, ordering rules are necessary to coordinate the different inclusion rules, which are as follows:
Notice that the calculation of the amounts of the two inclusions under Subpart F are separated by application of the rules that apply to dividends, and one Subpart F inclusion is given priority.
Under the ordering rules, the first step is to determine whether a CFC has any Subpart F income for the year. Such income can include dividends, interest, foreign base company sales income, or foreign base company services income.3 The net amount of such items (after allocating deductions) is included in the gross income of the U.S. shareholders.4
The amount of a CFC's Subpart F income included in the gross income of the U.S. shareholders is limited to the CFC's current year earnings and profits.5 For this purpose, the CFC's earnings and profits are determined without reduction for any distributions made during the year.6 This is the result even though Subpart F income is calculated as of the end of the CFC's taxable year and is deemed distributed to the U.S. shareholders on that day.7
The next step is to analyze any distributions made by the CFC during the year. Amounts subject to taxation under §951(a) are excluded from the income of the U.S. shareholders when distributed as a dividend. Distributions are treated as paid out of a CFC's previously taxed income first (for all years), and then out of non-previously taxed income.8 For this purpose, previously taxed income ("PTI") includes amounts taxable to the U.S. shareholders as Subpart F income for the year of the dividend.9
Example 1. USP owns all of the stock of CFC, which is a calendar year taxpayer. During 2012, CFC has $100 of Subpart F income and $150 of earnings and profits (and no PTI from prior years). CFC pays a dividend of $125 to USP on January 31, 2012. Even though as of the end of CFC's taxable year CFC has only $25 of undistributed current year earnings, the entire $100 of Subpart F income is included in USP's income under §951(a). Furthermore, $100 of the $125 distributed during 2012 is excluded from USP's income as a distribution of PTI.
The effect of the ordering rule under the above facts is that $100 is taxable to the U.S. shareholder as Subpart F income rather than as a dividend (which generally would not have a different tax result for a first-tier CFC).10 It is noted that if the CFC had PTI from prior years in excess of $25, the entire amount of the distribution would be excluded from the U.S. shareholder's income, even though the CFC would have $50 of current year non-PTI earnings.11
Under the ordering rules, the third determination is the amount of inclusions in the income of the U.S. shareholders from a CFC's investment in U.S. property. Such an inclusion can result from loans to related U.S. persons or investments in tangible property located in the United States, and is calculated based on an average of the amounts of such investments outstanding on the last day of each quarter.12 The ordering rules provide that the investment in U.S. property rules are applied taking into account the CFC's Subpart F income and distributions for the taxable year.13
The amount included in the income of the U.S. shareholders resulting from a CFC's investment in U.S. property is limited to the CFC's current and accumulated earnings and profits. The current year earnings and profits taken into account are determined as of the last day of the taxable year.14 Therefore, for this purpose, the time during a year when a U.S. property investment is made is irrelevant (although the amount of the investment is determined on the basis of a quarterly average).
In calculating the amount taxable to the U.S. shareholders, the amount of the investment in U.S. property is reduced by the CFC's current year and accumulated PTI.15 Because Subpart F income is determined first, PTI resulting from a current year Subpart F income inclusion reduces the amount of the U.S. property investment that is included in the income of the U.S. shareholders.16
Example 2. Assume the same facts as Example 1, except CFC does not make a distribution during 2012. Instead, CFC makes an investment in U.S. property during January of 2012 in the amount of $125. The amount of the U.S. property investment taxable to USP would be $25, since $100 would be considered as an investment of the PTI resulting from the current year Subpart F income inclusion.
Therefore, paying a $125 dividend or making a $125 investment in U.S. property generally should have the same U.S. tax result for a first-tier CFC. However, if CFC makes a $125 investment in U.S. property, as of the end of 2012 CFC will have $125 of PTI.
The amount taxable to USP as an investment in U.S. property would change if the CFC also makes a dividend distribution during the taxable year, because the distribution is taken into account before determining the consequences of the investment in U.S. property.17
Example 3. Assume the same facts as Example 1 ($100 of Subpart F income and $125 distribution), except that in addition CFC made a $125 investment in U.S. property on March 1, 2012. Assume also that CFC has accumulated earnings of $1,000 (none of which is PTI). As in Example 1, USP would have $100 of Subpart F income and $25 of dividend income. In addition, it would include in its gross income $125 as an investment in U.S. property (total of $250 included in USP's income).
Because the ordering rules determine the amount invested in U.S. property taking into account distributions for the year, the PTI resulting from the Subpart F income inclusion is treated as already having been distributed, and therefore does not reduce the amount included in USP's income as an investment in U.S. property.
Under the ordering rules, PTI resulting from an investment in U.S. property cannot be considered distributed in the same year that the amount is included in the income of the U.S. shareholders (the opposite of the rule that applies to Subpart F income inclusions). As seen in the above example, $25 of the distribution was included in the income of USP even though the investment in U.S. property resulted in $125 of PTI. This is because the amount of PTI taken into account for purposes of distributions is determined before applying the investment in U.S. property rules.
The ordering rules require coordination of the conversion of a §956 investment to an actual distribution.
Example 4. Assume the facts of Example 2 ($100 of Subpart F income and a $125 investment in U.S. property, but no dividend during 2012), and that CFC has no Subpart F income during 2013. It is desired, in 2013, for CFC to withdraw the value of $125 invested in U.S. property and distribute $125 to USP. Assume that on April 1, 2013, USP repays its loan to CFC. On April 2, 2013, CFC makes a distribution of $125 to USP. Under the ordering rules, the $125 distribution from CFC to USP is treated as occurring first and is paid out of CFC's PTI from 2012, and therefore is nontaxable. Next, CFC's investment in U.S. property for 2013 must be determined. CFC will not be considered as having any remaining PTI from 2012 because it will have been treated as distributed to USP. As a result, CFC will be considered to have invested $31 of non-PTI in U.S. property for 2013 ($125 investment outstanding for one quarter).
This U.S. property inclusion can be avoided by USP's repaying the loan before the last day of the first quarter of 2013 or, if repaid during the second quarter, distributing only a $94 dividend during 2013.
In light of the ordering rules, if there is a risk that the IRS might assert that certain property held by a CFC should be considered to be U.S. property, retaining PTI in the CFC would reduce or avoid a taxable inclusion. Retaining PTI also would reduce or avoid a taxable inclusion in a situation where there is some risk of the IRS asserting that a transaction resulted in a deemed dividend to the U.S. shareholder. In both situations, a proposed IRS adjustment would not be taxable to the extent of the CFC's PTI.18
The coordinating rules also can be strategically applied when repatriating high-taxed earnings. It may be desired to distribute all of a CFC's earnings and profits to bring all of the CFC's foreign taxes into the U.S. tax return for the year. If there is some uncertainty concerning the amount of a CFC's earnings and profits, consideration may be given to distributing an amount greater than the calculated earnings and profits, but a distribution in excess of earnings could result in gain under §301(c)(3). Alternatively, an investment could be made in U.S. property in excess of the CFC's earnings and profits. In that case, there would be no deemed distribution of the excess amount (i.e., the amount of the deemed distribution is limited to the CFC's earnings and profits and PTI created by the investment in U.S. property does not reduce the deemed dividend amount for the current year).
While the same ordering rules apply, additional considerations must be taken into account when the Subpart F inclusions and distributions are from a lower-tier CFC. A "hopscotch" rule applies to Subpart F inclusions, but not to dividends, which can affect the application of the foreign tax credit rules (and the Subpart F high-tax exception).19 In addition, distributions of PTI up through a chain of CFCs necessitates additional analysis at each level. 20
This commentary also will appear in the October 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder & Kemm, 930 T.M., CFCs-Sections 959-965 and 1248, and in Tax Practice Series, see ¶7150, U.S. Persons-Worldwide Taxation.
1 Proposed regulations would provide clear guidance concerning the current ordering rules. Prop. Regs. §§1.959-1(a), -3(e), REG-121509-00, 71 Fed. Reg. 51155 (8/29/06); see Yoder, "PTI Sharing Under the Proposed §959 Regulations," 35 Tax Mgmt. Int'l J. 636 (12/8/06).
2 §§301, 951(a).
3 §§952(a), 954(a).
4 See also §954(b)(3)(A) (de minimis exception), (b)(3)(B) (full inclusion rule), (b)(4) (high-tax exception), and §952(c)(2) (recapture rule); Regs. §1.954-1(a).
5 §952(c)(1)(A); Regs. §1.952-1(e). Current year earnings and profits are not reduced by accumulated deficits (the same as the "nimble" dividend rule in §316(a)(2)). Cf. §952(c)(2)(B) and (C) (accumulated and chain deficit rules reduce Subpart F income in certain categories).
6 See Regs. §1.952-1(c)(1) (first paragraph), (c)(3) Ex. 1(c) and (d), and (f)(4) Ex. 4; see also Prop. Regs. §1.959-3(a), (e).
13 Note that the ordering rules for U.S. property investments were changed in 1993, and the regulations have not been updated to reflect the change. See H.R. Rep. No. 111, 103d Cong., 1st Sess. (1993).
19 The hopscotch rule does not apply for foreign tax credit purposes to certain inclusions resulting from investments in U.S. property. §960(c); Yoder, "Section 956 Inclusions: New Limit on Foreign Taxes Deemed Paid," 39 Tax Mgmt. Int'l J. 785 (12/10/10).
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