Client Alert

New Section 956 Regulations Expand Scope of the New Participation Exemption But May Expose Borrowers to Increased Collateral Requirements

09 Nov 2018

On October 31, 2018, the Internal Revenue Service and the Treasury Department issued proposed regulations that would limit the application of Section 956 of the Internal Revenue Code (the “Code”) in an attempt to align it with the participation exemption enacted as part of the Tax Cuts and Jobs Act (the “TCJA”).[1] Taxpayers may rely on the proposed regulations for tax years of their foreign subsidiaries beginning after December 31, 2017.

In short, the proposed regulations should both (1) reduce taxable income inclusions resulting from investments in U.S. property, and (2) significantly expand the ability of lenders to require U.S. corporations to pledge their foreign subsidiaries as collateral in connection with commercial financing transactions.

Background on Section 956

Section 956 is one component of Subpart F of the Code, an anti-deferral regime that accelerates recognition of certain types of income for “U.S. Shareholders” of a “controlled foreign corporation” (“CFC”). A “U.S. Shareholder” (as expanded by the TCJA) is a U.S. individual or entity that owns at least 10% of the total combined voting power or at least 10% of the value of all classes of stock of a CFC. A “CFC” is a foreign corporation of which more than 50% of the total combined voting power or value is owned by U.S. Shareholders. Under Subpart F, a U.S. Shareholder is required to include certain amounts (generally, certain enumerated categories of passive income, often referred to as “Subpart F income”) in current income with respect to its CFCs, even if the U.S. Shareholder receives no corresponding cash distributions.

In addition to including its share of “Subpart F income” whether or not distributed currently, a U.S. Shareholder also is required to include under Subpart F an amount, determined under Section 956, which generally is intended to correspond to the CFC’s untaxed earnings that are invested in U.S. property. The theory of this Section 956 inclusion has been that the investment in U.S. property is tantamount to the CFC’s payment of a dividend to the U.S. Shareholder followed by a U.S. property investment by the U.S. Shareholder. Specifically, the Section 956 amount is the lesser of (i) the U.S. Shareholder’s pro rata share of the average of the amounts of U.S. property held by the CFC at the end of each quarter of the year, and (ii) the current and accumulated earnings and profits of the CFC that have not been previously subject to U.S. taxation with respect to the U.S. Shareholder. For this purpose, an investment in U.S. property includes, with certain exceptions, tangible and intangible personal property, real property, and obligations issued by the CFC’s U.S. Shareholders and affiliates. A CFC is also considered to be invested in U.S. property if it supports a borrowing of a U.S. Shareholder by guaranteeing the debt, pledging its own assets to support the debt, or having more than two-thirds of its stock pledged to support the debt.

As a result of the foregoing Section 956 rules, historically it has been standard practice for commercial lending documentation to require that multinational groups forgo any guarantee of U.S. borrowings by CFC members of the group, and to limit the pledge of CFC member shares to only two-thirds of the shares of any first-tier CFCs (since lower-tier shares would represent a pledge of property by a CFC itself).

Changes Made by the TCJA

Section 245A, adopted as part of the TCJA, creates a modified participation exemption, under which U.S. corporate shareholders who own at least 10% of a foreign corporation may deduct 100% of the foreign-source portion of the dividends received from that corporation if certain requirements are met. However, no changes were made to Section 956 as part of the TCJA. As a result, in the absence of the proposed regulations, an actual cash dividend distribution from a CFC to a U.S. Shareholder could be free from U.S. tax, but a deemed dividend resulting from that CFC’s guarantee of its U.S. parent’s debt ordinarily could result in U.S. tax.[2]

In addition, under Section 245A, no foreign tax credits are allowed with respect to excluded dividends. In contrast, because Section 956 income inclusions have not been eligible for the Section 245A deduction, foreign tax credits have continued to be allowable with respect to income included under Section 956. Accordingly, without the proposed regulations, sophisticated taxpayers may be able to use Section 956 to generate excess foreign tax credits beyond the amount needed to offset their Section 956 deemed dividend and claim this excess to offset U.S. tax on other foreign-source income in the same limitation basket. Since the TCJA was enacted, most corporate taxpayers have had at least some ability to elect whether to distribute cash out of a CFC (which may be excluded from income but would not free up foreign tax credits), or instead to cause the CFC to loan the same amount of cash to its U.S. Shareholder (which may be taxable under Section 956 but also could make available excess foreign tax credits).

Proposed Regulations

The proposed regulations reduce a U.S. Shareholder’s Section 956 amount by the deduction the taxpayer would have been allowed if the Section 956 amount were eligible for the Section 245A dividends received deduction. See Proposed Regulations Section 1.956-1(a)(2). Effectively, this rule eliminates the Section 956 inclusion (along with any related foreign tax credits) in many commonly encountered circumstances. However, there are several situations in which the proposed regulations would not reduce a U.S. Shareholder’s Section 956 amount. For example, taxpayers who are ineligible for Section 245A, such as regulated investment companies, real estate investment trusts, non-corporate entities, and individuals (including those who make an election under Section 962 to be treated as a corporation for certain Subpart F purposes) would not benefit from the proposed regulations. (With respect to partnerships, the proposed regulations request comments from taxpayers as to the appropriate application of the rules.) In addition, the proposed regulations would not reduce the Section 956 amount in cases where a U.S. Shareholder has held its CFC stock for less than the required 365-day holding period, a CFC has U.S.-source earnings, a U.S. Shareholder has hedged its investment in the CFC, or a U.S. Shareholder’s CFC stock gives rise to a deduction or other tax benefit to the CFC (for example, where dividends paid to the U.S. Shareholder are treated as deductible interest payments in the CFC’s home country).[3]

Planning Considerations

Given the number of situations in which the proposed regulations effectively neutralize Section 956, U.S. multinationals may consider whether it makes sense to re-think their tax planning and financial strategies. They may want to cause their CFCs to begin investing directly in property in the United States (for example, potentially lending funds to a U.S Shareholder if a dividend payment to that shareholder would be subject to withholding tax by the CFC’s home country). They also may wish to reconsider (or may be required by their lender to revise) their financing arrangements, including relaxing or eliminating the limitations on collateral packages that include foreign subsidiaries (such as CFC guarantees of U.S. parent debt and pledges of the shares of CFC subsidiaries). However, these choices necessarily will include an analysis of other factors, including withholding taxes, branch profits tax rules, permanent establishment rules, foreign taxation, and local legal limitations. Among other things, before agreeing to expand the reach of collateral packages to encompass all CFCs, U.S. multinationals should conduct the necessary diligence to ensure a dividend paid by that CFC would qualify for the Section 245A deduction. For example, a multinational would want to confirm that its CFCs have no “hybrid” financing arrangements in their capital structures and determine whether any of its CFCs have U.S. earnings that would be subject to taxation on a deemed repatriation before agreeing to make changes to its debt collateral packages.

Finally, the proposed regulations may eliminate the ability of U.S. multinationals to utilize excess foreign tax credits under Section 956 because Section 245A disallows foreign tax credits associated with the dividend giving rise to the deduction. Although taxpayers are permitted to rely on the proposed regulations prior to the date they are finalized, taxpayers in a position to benefit from accessing excess foreign tax credits may wish to consider the possibility of continued reliance on the current Section 956 rules until the proposed regulations are finalized.


[1] Unless otherwise indicated, all Section references herein are to the Code.

[2] As described in more detail below, a taxpayer may find that the benefit afforded by the proposed regulations does not result in 100% elimination of taxable income, given the interplay of all of the relevant rules. It therefore would be wise to conduct a detailed analysis of the impact of any restructuring or income inclusion required under Section 965 before agreeing to make wholesale changes to an existing loan or corporate structure.

[3] See Section 245A(e).

Please contact any of the authors listed above or your regular Morrison & Foerster contact to discuss any questions regarding the content of this alert or any related issues.

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