By Anthony Diosdi
Internal Revenue Code Section 956 provides that a U.S. shareholder of a controlled foreign corporation or “CFC” must include in his or her income his or her pro rata share of the CFC’s increase in its earnings and profits or E&P invested in U.S. property for the taxable year. For purposes of Section 956, U.S. property includes most tangible and intangible property owned by the CFC. In enacted Section 956, Congress concluded that if any CFC loaned its accumulated earnings to its U.S. shareholders, earnings to the U.S. shareholders had occurred and, consequently, the loan should be treated as a constructive dividend. This treatment tax is based on the theory that, because the U.S. shareholder has use of the money loaned to it, it could reasonably be treated as if it had received the funds as a dividend even though it had an unconditional obligation to repay the principal of the loan.
For example, let’s assume that on January 1 of last year, DC, a U.S. corporation, formed a wholly owned foreign subsidiary, FC, which is a CFC. FC is engaged in a foreign business that generated $100,000 of net income during last year. On February 1 of last year, FC made a bona fide loan of $100,000 to DC and such loan remained outstanding at the end of the year. Under Section 956, the loan from FC to DC is treated as an investment of FC’s earnings in U.S. property. Thus, DC must include $10,000 in gross income as if FC had distributed that amount to DC.
It is fundamentally worth noting that Section 956 diminished its relevance in the context of cross-border intercompany loans after the enactment the 2017 Tax Cuts and Jobs Act, because the Section 965 transition tax eliminated most untaxed offshore E&P, leaving large pools of previously taxed E&P that will ultimately be repatriated to the U.S. without additional tax. In addition, the global low-taxed income or GILTI causes most foreign source income to be taxed. Thus, this discussion is limited to foreign E&P that is the result of 10 percent QBAI from GILTI or taxable income deferred under the Section 954 ight tax election.
At one time a CFC measured its investment in U.S. property for Section 956 purposes at the end of the tax year. CFCs used this to their advantage by making intercompany loans to their U.S. parent corporations at the start of each tax year and repaying the debt just before the end of the tax year. In form, the CFC would never have a 956 inclusion because the loan was repaid before the end of the tax year. However, in substance, the U.S. parent had use of the CFC untaxed funds for almost a year. In cases of circular loans, the U.S. parent could have use of the CFC untaxed funds for much longer than a year. In order to prevent this perceived abuse, the IRS enacted Rev. Rul. 89-73, 1989-1 C.B. 258.
This Revenue Rule provides that a CFC must determine the amount invested in U.S. property based on the average at the end of each quarter, rather than at the end of the year. This makes it more difficult to arrange short-term financing of U.S. activities from a CFC without generating a Section 956 constructive dividend.
For most CFC shareholders that are taxed as Subchapter C corporations a 956 inclusion will not be an issue because of the Section 245A dividend received deduction. Section 245A permits an exemption for certain foreign income of a domestic C corporation that is a U.S. shareholder as a result of a 100 percent dividends received deduction or DRD for the foreign-source portion of dividends received from specified 10-percent owned foreign corporations by certain domestic corporations that are U.S. shareholders of those foreign corporations. Individual U.S. shareholders of a CFC do not qualify for a Section 245A DRD deduction. Consequently, individual U.S. shareholders of domestic corporations will be the one assessed an income taxed liability under Section 956 inconnection with an intercompany loan.
Section 956 may be triggered anytime a U.S.-based multinational corporation deliberately causes its controlled foreign corporations to lend funds to its U.S. parent corporation. Such a transaction may trigger significant constructive dividends to be assessed to the shareholders of the U.S. parent corporation. The U.S. taxation of cross-border loans can be extremely complicated. Multinational corporations are advised to seek the advice of a competent international tax attorney when planning cross-border loans.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
By Anthony Diosdi