The Treasury Department and the IRS have determined that as a result of the enactment of the participation exemption system, the current broad application of section 956 to corporate U.S. shareholders would be inconsistent with the purposes of section 956 and the scope of transactions it is intended to address. Congress determined that certain investments by a CFC of its earnings in United States property are “substantially the equivalent of a dividend” and enacted section 956 to provide similar treatment for dividends and certain investments in United States property constituting effective repatriations. S. Rep. No. 1881 at 88. Before the Act, section 956 applied appropriately to domestic corporations because both dividends from, and investments in United States property by, CFCs were included in income by such domestic corporations. As noted, the purpose of section 956 is generally to create symmetry between the taxation of actual repatriations and the taxation of effective repatriations, by subjecting effective repatriations to tax in the same manner as actual repatriations. Under the participation exemption system, however, earnings of a CFC that are repatriated to a corporate U.S. shareholder as a dividend are typically effectively exempt from tax because the shareholder is generally afforded an equal and offsetting dividends received deduction under section 245A. A section 956 inclusion of a corporate U.S. shareholder, on the other hand, is not eligible for the dividends received deduction under section 245A (because it is not a dividend). As a result, the application of section 956 after the Act to corporate U.S. shareholders of CFCs that would qualify for section 245A deductions would result in disparate treatment of actual dividends and amounts “substantially the equivalent of a dividend”—a result directly at odds with the manifest purpose of section 956.

Accordingly, the proposed regulations continue the Treasury Department and the IRS’s longstanding practice of conforming the application of section 956 to its purpose. The proposed regulations exclude corporate U.S. shareholders from the application of section 956 to the extent necessary to maintain symmetry between the taxation of actual repatriations and the taxation of effective repatriations. In general, under section 245A and the proposed regulations, respectively, neither an actual dividend to a corporate U.S. shareholder, nor such a shareholder’s amount determined under section 956, will result in additional U.S. tax.

To achieve this result, the proposed regulations provide that the amount otherwise determined under section 956 with respect to a U.S. shareholder for a taxable year of a CFC is reduced to the extent that the U.S. shareholder would be allowed a deduction under section 245A if the U.S. shareholder had received a distribution from the CFC in an amount equal to the amount otherwise determined under section 956. The proposed regulations provide special rules with respect to indirect ownership. Due to the broad applicability of section 245A, in many cases a corporate U.S. shareholder will not have a section 956 inclusion as a result of a CFC holding U.S. property under the proposed regulations.

Section 956 will continue to apply without modification to U.S. shareholders other than corporate U.S. shareholders, such as individuals, to ensure that, consistent with the purposes of section 956, amounts that are substantially the equivalent of a dividend will be treated similarly to actual dividends. This treatment will apply to individuals regardless of whether they make an election under section 962. Because individuals are not eligible for a dividends received deduction under section 245A even if they make an election under section 962, the current application of section 956 to individuals is still necessary to ensure substantial equivalence between an actual repatriation and a deemed repatriation. Similarly, section 956 will continue to apply without reduction to regulated investment companies and real estate investment trusts because they are not allowed the dividends received deduction under section 245A. See sections 852(b)(2)(C) and 857(b)(2)(A).

In addition to carrying out the purposes of section 956, the proposed regulations would significantly reduce complexity, costs, and compliance burdens for corporate U.S. shareholders of CFCs. Absent the proposed regulations, corporate U.S. shareholders would need to continue to carefully monitor the application of section 956 to their operations, including provisions related to loans, guarantees, and pledges, to ensure that earnings were repatriated only through actual dividends, and therefore allowed a participation exemption, rather than through a deemed repatriation under section 956 subject to additional U.S. tax. Similarly, in the absence of the proposed regulations, a U.S.-parented group in many cases would need to engage in complex and costly restructuring upon the acquisition of a foreign corporation that owns domestic subsidiaries (since the foreign corporation becomes a CFC and the stock of its domestic subsidiaries represents United States property) solely to avoid a section 956 inclusion. Absent the proposed regulations, section 956 could also serve as a “trap for the unwary” for domestic corporations that fail to recognize that, even though they are entitled to the deduction under section 245A for actual dividends, their section 956 inclusions would continue to be fully subject to U.S. tax.

The proposed regulations also add, in proposed § 1.956–1(g)(5), the effective date for § 1.956–1(e)(6) that was inadvertently deleted in TD 9792, published in the Federal Register on November 3, 2016 (81 FR 76497, as corrected at 81 FR 95470 and 95471).

The Treasury Department and the IRS intend to make conforming amendments to the examples throughout the regulations under section 956 upon finalization of the proposed regulations.

These changes are proposed to apply to taxable years of a CFC beginning on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register (the “finalization date”), and to taxable years of a U.S. shareholder in which or with which such taxable years of the CFC end. With respect to taxable years of a CFC beginning before the finalization date, a taxpayer may rely on the proposed regulations for taxable years of a CFC beginning after December 31, 2017, and for taxable years of a U.S. shareholder in which or with which such taxable years of the CFC end, provided that the taxpayer and United States persons that are related (within the meaning of section 267 or 707) to the taxpayer consistently apply the proposed regulations with respect to all CFCs in which they are U.S. shareholders.

The Administrator of the Office of Information and Regulatory Affairs (OIRA), Office of Management and Budget, has waived review of this proposed rule in accordance with section 6(a)(3)(A) of Executive Order 12866. OIRA will subsequently make a significance determination of the final rule, pursuant to section 3(f) of Executive Order (E.O.) 12866 and the April 11, 2018, Memorandum of Agreement between the Department of Treasury and the Office of Management and Budget (OMB).

Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it is hereby certified that this regulation, if adopted, will not have a significant economic impact on a substantial number of small entities, although some small entities that are domestic corporations could be affected by the regulation and comments are requested on the application of the regulation to domestic partnerships. However, even if a substantial number of small entities were to be affected by this regulation, the Treasury Department and the IRS estimate that the economic impact on such small entities would not be significant as the regulation is expected to marginally reduce compliance costs for smaller entities. This is because the Treasury Department and the IRS believe that the cost-saving benefits of the proposed regulations with respect to complex third-party borrowing arrangements, internal financial management structures, and restructurings of worldwide operations will generally be available only to large U.S. multinational corporations with 20 or more CFCs. The Treasury Department and the IRS believe that U.S. multinational corporations with less than 20 CFCs generally will not have the types of arrangements in place that would otherwise need to be structured and monitored to avoid section 956. The proposed regulations, if adopted, generally will not affect small entities that are not domestic corporations. The Treasury Department and the IRS invite comments on the impact of this rule on small entities.

Pursuant to section 7805(f), this notice of proposed rulemaking has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small businesses.

Before these proposed regulations are adopted as final regulations, consideration will be given to any comments that are submitted timely to the IRS as prescribed in this preamble under the “Addresses” heading. The Treasury Department and the IRS request comments on all aspects of the proposed rules. In particular, comments are requested as to the appropriate application of the proposed regulations to U.S. shareholders that are domestic partnerships, which may have partners that are a combination of domestic corporations, U.S. individuals, or other persons. For example, one approach could be to reduce the amount otherwise determined under section 956 with respect to a domestic partnership to the extent that a domestic corporate partner would be entitled to a section 245A deduction if the partnership received the amount as a distribution. An alternative could be to determine a domestic partnership’s section 956 amount and section 956 inclusion without regard to the status of its partners, but then provide that a corporate U.S. shareholder partner’s distributive share of the section 956 inclusion is not taxable. Comments are also requested with respect to the maintenance of previously taxed earnings and profits accounts under section 959 and basis adjustments under section 961. Additionally, comments are requested on the interaction between the proposed regulations and section 245A(e). All comments will be available at http://www.regulations.gov or upon request.

A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register.

Income taxes, Reporting and recordkeeping requirements.

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

Paragraph 1. The authority citation for part 1 is amended by adding an entry to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.956–1 also issued under 26 U.S.C. 245A(g) and 956(e).

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Par. 2. Section 1.956–1 is amended by:

1. Revising paragraph (a).

2. In the first sentence of paragraph (g)(1), removing the language “Paragraph (a)” and adding in its place “Paragraph (a)(1)”.

3. Adding paragraphs (g)(4) and (5).

The revisions and additions read as follows:

(a) Overview and scope–(1) In general. Subject to the provisions of section 951(a) and the regulations thereunder, a United States shareholder of a controlled foreign corporation is required to include in gross income the amount determined under section 956 with respect to the shareholder for the taxable year but only to the extent not excluded from gross income under section 959(a)(2) and the regulations thereunder.

(2) Reduction for certain United States shareholders–(i) In general. For a taxable year of a controlled foreign corporation, the amount determined under section 956 with respect to each share of stock of the controlled foreign corporation owned (within the meaning of section 958(a)) by a United States shareholder is the amount that would be determined under section 956 with respect to such share for the taxable year, absent the application of this paragraph (a)(2) for the taxable year (such amount, the tentative section 956 amount, and in the aggregate with respect to all shares owned (within the meaning of section 958(a)) by the United States shareholder, the aggregate tentative section 956 amount), reduced by the amount of the deduction under section 245A that the shareholder would be allowed if the shareholder received as a distribution from the controlled foreign corporation an amount equal to the tentative section 956 amount with respect to such share on the last day during the taxable year on which the foreign corporation is a controlled foreign corporation (hypothetical distribution).

(ii) Determination of the amount of the deduction that would be allowed under section 245A with respect to a hypothetical distribution. For purposes of determining the amount of the deduction under section 245A that a United States shareholder would be allowed with respect to a share of stock of a controlled foreign corporation by reason of a hypothetical distribution, the following rules apply–

(A) If a United States shareholder owns a share of stock of a controlled foreign corporation indirectly (within the meaning of section 958(a)(2)), then–

(1) Sections 245A(a) through (d), 246(a), and 959 apply to the hypothetical distribution as if the United States shareholder directly owned (within the meaning of section 958(a)(1)(A)) the share;

(2) Section 245A(e) applies to the hypothetical distribution as if the distribution were made to the United States shareholder through each entity by reason of which the United States shareholder indirectly owns such share and pro rata with respect to the equity that gives rise to such indirect ownership;

(3) To the extent that a distribution treated as made to a controlled foreign corporation pursuant to the hypothetical distribution by reason of paragraph (a)(2)(ii)(A)(2) of this section would be subject to section 245A(e)(2), the United States shareholder is treated as not being allowed a deduction under section 245A by reason of the hypothetical distribution; and

(4) Section 246(c) applies to the hypothetical distribution by substituting the phrase “owned (within the meaning of section 958(a))” for the term “held” each place it appears in section 246(c); and

(B) Section 246(c) applies to the hypothetical distribution by substituting “the last day during the taxable year on which the foreign corporation is a controlled foreign corporation” for the phrase “the date on which such share becomes ex-dividend with respect to such dividend” in section 246(c)(1)(A).

(3) Examples. The following examples illustrate the application of paragraph (a)(2) of this section.

(i) Example 1. (A) Facts. (1) USP, a domestic corporation, owns all of the single class of stock of CFC1, which is treated as equity for U.S. income tax purposes and under the laws of the jurisdiction in which CFC1 is organized and liable to tax as a resident. The stock of CFC1 consists of 100 shares, and USP satisfies the holding period requirement of section 246(c) (as modified by paragraph (a)(2)(ii)(B) of this section) with respect to each share of CFC1 stock. CFC1 owns all of the stock of USS, a domestic corporation. CFC1’s adjusted basis in the stock of USS is $0x.

(2) The functional currency of CFC1 is the U.S. dollar. CFC1 has $100x of undistributed earnings as defined in section 245A(c)(2), $90x of which constitute undistributed foreign earnings as defined in section 245A(c)(3), and $10x of which are described in section 245(a)(5)(B) (that is, earnings attributable to a dividend that CFC1 received from USS). CFC1 would not receive a deduction or other tax benefit with respect to any income, war profits, or excess profits taxes on a distribution. None of the earnings and profits of CFC1 are described in section 959(c)(1) or (2) or are earnings and profits attributable to income excluded from subpart F income under section 952(b). CFC1’s applicable earnings (as defined in section 956(b)(1)) are $100x. CFC1 also has held an obligation of USP with an adjusted basis of $120x on every day during the taxable year that was acquired while all of its stock was owned by USP.

(B) Analysis. Because USP directly owns all of the stock of CFC1 at the end of CFC1’s taxable year, USP’s aggregate tentative section 956 amount with respect to CFC1 is $100x, the lesser of USP’s pro rata share of the average amounts of United States property held by CFC1 ($120x) and its pro rata share of CFC1’s applicable earnings ($100x). Under paragraph (a)(2)(i) of this section, USP’s section 956 amount with respect to CFC1 is its aggregate tentative section 956 amount with respect to CFC1 reduced by the deduction under section 245A that USP would be allowed if USP received an amount equal to its aggregate tentative section 956 amount as a distribution with respect to the CFC1 stock. With respect to the tentative distribution from CFC1 to USP, USP would be allowed a $90x deduction under section 245A with respect to the foreign-source portion of the $100x hypothetical distribution (that is, an amount of the dividend that bears the same ratio to the dividend as the $90x of undistributed foreign earnings bears to the $100x of undistributed earnings). Accordingly, USP’s section 956 amount with respect to CFC1 is $10x, its aggregate tentative section 956 amount ($100x) with respect to CFC1 reduced by the amount of the deduction that USP would have been allowed under section 245A with respect to the hypothetical distribution ($90x).

(ii) Example 2. (A) Facts. The facts are the same as in paragraph (A) of Example 1 in paragraph (a)(3)(i) of this section, except that all $100x of CFC1’s undistributed earnings are described in section 959(c)(2).

(B) Analysis. As in paragraph (B) of Example 1 in this paragraph (a)(3)(i) of this section, USP’s aggregate tentative section 956 amount with respect to CFC1 is $100x, the lesser of USP’s pro rata share of the average amounts of United States property held by CFC1 ($120x) and its pro rata share of CFC1’s applicable earnings ($100x). However, paragraph (a)(2) of this section does not reduce USP’s section 956 amount, because USP would not be allowed any deduction under section 245A with respect to the $100x hypothetical distribution by reason of section 959(a) and (d). Accordingly, USP’s section 956 amount is $100x. However, under sections 959(a)(2) and 959(f)(1), USP’s inclusion under section 951(a)(1)(B) with respect to CFC1 is $0, because USP’s section 956 amount with respect to CFC1 does not exceed the earnings and profits of CFC1 described in section 959(c)(2) with respect to USP. The $100x of earnings and profits of CFC1 described in section 959(c)(2) are reclassified as earnings and profits described in section 959(c)(1).

(iii) Example 3. (A) Facts. (1) USP, a domestic corporation, owns all of the single class of stock of CFC1, and has held such stock for five years. CFC1 has held 70% of the single class of stock of CFC2 for three years. The other 30% of the CFC2 stock has been held by a foreign individual unrelated to USP or CFC1 since CFC2’s formation. All of the stock of each of CFC1 and CFC2 is treated as equity for U.S. income tax purposes and under the laws of the jurisdiction in which each respective corporation is organized and liable to tax as a resident. CFC2 has a calendar taxable year. On December 1, Year 1, CFC1 acquires the remaining 30% of the stock of CFC2 for cash. On June 30, Year 2, CFC1 sells to a third party the 30% of CFC2 stock acquired in Year 1 at no gain. CFC2 made no distributions during Year 1.

(2) The functional currency of CFC1 and CFC2 is the U.S. dollar. CFC2 has $120x of undistributed earnings as defined in section 245A(c)(2), all of which constitute undistributed foreign earnings. Neither CFC1 nor CFC2 would receive a deduction or other tax benefit with respect to any income, war profits, or excess profits taxes on a distribution. None of the earnings and profits of CFC2 are described in section 959(c)(1) or (2) or are earnings and profits attributable to income excluded from subpart F income under section 952(b). CFC2’s applicable earnings (as defined in section 956(b)(1)) are $120x. CFC2 has held an obligation of USP with an adjusted basis of $100x on every day of Year 1 that was acquired while USP owned all of the stock of CFC1 and CFC1 held 70% of the single class of stock of CFC2.

(B) Analysis. Because USP indirectly owns (within the meaning of section 958(a)) all of the stock of CFC2 at the end of Year 1, USP’s aggregate tentative section 956 amount with respect to CFC2 for Year 1 is $100x, the lesser of USP’s pro rata share of the average amounts of United States property held by CFC2 ($100x) and its pro rata share of CFC2’s applicable earnings ($120x). Under paragraph (a)(2)(i) of this section, USP’s section 956 amount with respect to CFC2 for Year 1 is its aggregate tentative section 956 amount with respect to CFC2 reduced by the deduction under section 245A that USP would be allowed if USP received an amount equal to its aggregate tentative section 956 amount as a distribution with respect to the CFC2 stock that USP owns indirectly within the meaning of section 958(a)(2). For purposes of determining the consequences of this hypothetical distribution, under paragraph (a)(2)(ii)(A)(1) of this section, USP is treated as owning the CFC2 stock directly. In addition, under paragraph (a)(2)(ii)(A)(4) of this section, the holding period requirement of section 246(c) is applied by reference to the period during which USP owned (within the meaning of section 958(a)) the stock of CFC2. Therefore, with respect to the hypothetical distribution from CFC2 to USP, USP would satisfy the holding period requirement under section 246(c) with respect to the 70% of the CFC2 stock that USP indirectly owned for three years through CFC1, but not with respect to the 30% of the CFC2 stock that USP indirectly owned through CFC1 for a period of less than 365 days. Accordingly, USP’s section 956 amount with respect to CFC2 for Year 1 is $30x, its aggregate tentative section 956 amount ($100x) reduced by the amount of the deduction that USP would have been allowed under section 245A with respect to the hypothetical distribution ($70x).

* * * * *

(g) * * *

(4) Paragraphs (a)(2) and (3) of this section apply to taxable years of controlled foreign corporations beginning on or after the date of publication of the Treasury decision adopting paragraphs (a)(2) and (3) of this section as final regulations in the Federal Register, and to taxable years of a United States shareholder in which or with which such taxable years of the controlled foreign corporation end.

(5) Paragraph (e)(6) of this section applies to property acquired in exchanges occurring on or after June 24, 2011.