On October 1, 2019, the Internal Revenue Service (IRS) issued two important proclamations. If you own stock in controlled foreign corporations (CFC), these updates could affect you.
The first was Revenue Procedure 2019-40, which adjusted procedures for determining CFC status and resulting income inclusions. At the same time, the IRS also issued proposed regulations to address concerns stemming from the repeal of Section 958(b)(4) by the Tax Cuts and Jobs Act (TCJA).
What do these new rules mean to you? Read on to learn more.
Background on Section 958(b)(4) Repeal
In 2017, a massive tax overhaul occurred under the TCJA, which included a repeal of IRS Section 958(b)(4). When this occurred, many foreign corporations that were not previously considered under the CFC umbrella suddenly became controlled foreign corporations for U.S. federal income tax purposes.
The repeal was first intended to curb certain transactions that taxpayers were using to minimize their Subpart F income. A common example was a “decontrolled transaction” wherein controlling U.S. shareholders would restructure their foreign subsidiaries in such a way that those previously deemed controlled foreign corporations would no longer be defined as such.
However, multiple, unintended issues arose from the repeal. Downward attribution is one of them.
The Issue with Downward Attribution
According to Sections 318(a)(3)(A), (B), and (C), stock that a person owns is attributed downward to any partnerships, trusts, estates or corporations in which that person has an interest.
Before its repeal, Section 958(b)(4) maintained that foreign corporations that were majority-owned by foreign shareholders could not be considered a CFC on the basis of downward attribution. The rule maintained that if a foreign person owned stock of both a U.S. corporation and a foreign corporation, he or she could not apply downward attribution of their stock ownership in the foreign corporation to the U.S. corporation.
After the repeal, the opposite became true.
Now, the foreign person’s stock in the foreign corporation is now attributable to the U.S. corporation. As a result, it can cause the foreign corporation to be treated as a CFC.
For clarity, Revenue Procedure 2019-40 refers to these newly-added CFCs as “foreign-controlled CFCs.”
What does this mean for U.S. shareholders?
If you own (directly or indirectly) between 10% and 50% of the stock of any foreign-controlled CFC, the repeal requires you to take into account Subpart F income or Global Intangible Low-Taxed Income (GILTI) income on your taxes.
The IRS’ new Revenue Procedure changes the method that U.S. shareholders will use to determine CFC status. If you own a stake of 50% or less in a foreign joint venture, the Revenue Procedure adjusts how you can determine if it’s categorized as a CFC.
The Safe Harbor
If you determine that a foreign corporation is not a CFC, the Revenue Procedure also explains that there are some situations in which the IRS will not challenge this assertation.
Known as “The Safe Harbor”, there are two requirements to getting this green light:
- The corporation in question must be a foreign-controlled CFC
- You’ll need to satisfy a “duty of inquiry”
Note that Safe Harbor only applies to foreign-controlled CFCs. In other words, it’s only applicable to foreign corporations that were CFCs or became CFCs due to downward attrition that occurred with the repeal of Section 958(b)(4).
What does the duty of inquiry entail?
In short, you’ll need to show that you’ve done your due diligence and attempted to find out as much as possible about the foreign corporation in which you directly own an interest. The IRS will require you to prove that:
- You do not have the actual knowledge, physical statements, or sufficient and reliable public information necessary to determine if the foreign corporation is a CFC
- You have asked the foreign corporation whether the entity is a CFC
- You have asked for any information on whether any of the entities subsidiaries might be a CFC
Changes to Income Reporting Procedures
If you complete this process and determine that you do own stock in a foreign-controlled CFC, the Revenue Procedure changes how you’ll report that income on your taxes.
Some U.S. owners of controlled foreign corporations have historically had difficulty obtaining the required information necessary to report their Subpart F income or GILTI income with exactitude. In this case, the new procedure allows these taxpayers to reference alternative information to calculate these categories on an estimated basis.
This alternative information can include separate entity financial statements (audited or unaudited) prepared in accordance with the following:
- Generally accepted U.S. accounting principles
- International financial reporting standards
- Generally accepted accounting principles of the foreign corporation’s jurisdiction
In addition, you can also reference records that the foreign corporation used for its own tax reporting or internal management processes.
When the repeal of Section 958(b)(4) first occurred, it triggered myriad technical issues and tax reporting problems. This is because, prior to the TCJA, Congress and the Treasury had established special rules for CFCs that did not take into account the inclusion of foreign-controlled CFCs.
In response, the IRS’ Proposed Regulations make adjustments and modifications to multiple U.S. tax provisions that govern how controlled foreign corporations are considered. Specific sections updated include:
Concerning Section 6049, the IRS maintains that it will not treat foreign-controlled CFCs as U.S. payers. Thus, such entities are exempt from Form 1099 reporting requirements and backup withholding methods. In addition, Section 267 updates help relieve amounts paid to treaty-eligible foreign-controlled CFCs.
These are only a few of the changes enacted under the Proposed Regulations. The full list is provided at the Federal Register.
Tax laws can be challenging to navigate. This is especially true if you own shares in a controlled foreign corporation.
As the IRS continues to propose and enact changes to its tax code, it’s more important than ever before to be aware of the updates. These recent adjustments affect CFC owners, in particular, but there are plenty of other adaptions that hold different implications for taxpayers around the country.
That’s why it pays to have a qualified and experienced tax attorney on your side.
We’ll help you solve and avoid any tax-related snafus you might face. From consulting services to tax fraud investigations, we do it all so you don’t have to. Contact us today for the expert advice and answers you need.