By Jerald David August, Chair, International Taxation and Wealth Planning Group
The government recently issued temporary regulations under section 245A which provides a 100% dividends received deduction (DRD) for certain dividends received by a US corporation from a current for former controlled foreign corporation (CFC) defined in section 957. The provision is frequently referred to as the participation exemption which many countries have already had in place with respect to their domestic corporations in investing in subsidiary or affiliate corporations overseas. The temporary regulations were published in TD 9865 and limit the section 245A DRD for certain dividends and further limit the section 954(c)(6) exception to foreign personal holding company income (FPHC) defined in section 954(c), for certain dividends received by upper-tier CFCs from lower-tier CFCs. Additional proposed regulations were issued as well. REG-106282-18.  The temporary regulations are effective on June 18, 2019 and have a retroactive effective date for distributions made after December 31, 2017.
Background of Section 245A
The Tax Cuts and Jobs Act of 2017, §14101(a), permits a domestic corporation that is a US shareholder of a specified 10% owned foreign corporation to claim a deduction equal to the foreign source portion of any dividend received from the specified 10% owned foreign corporation, i.e., the section 245A DRD. The revised definition of a US shareholder under section 951(b) applies for purposes of this rule which is now based on 10% or more of the voting or value of the CFC. Stock attribution rules continue to apply. A specified 10% owned foreign corporation is any foreign corporation with respect to which a domestic corporation is a US shareholder. However, the foreign corporation can not be a passive foreign investment company (PFIC) that is not a CFC after application of section 957()^^^ .
For section 245A purposes, the undistributed earnings are the earnings and profits (E&P) of the 10% owned specified foreign corporation determined under sections 964(a) and 986 as of the end of the foreign corporation’s tax year which is making the dividend without reduction for dividends distributed during the same tax year.  The undistributed foreign E&P can not be sourced from income that is effectively connected with the conduct of a US trade or business or any dividend received, directly or through a wholly owned foreign subsidiary corporation, from a domestic corporation where 80% or more of the stock (vote and value) is owned directly or indirectly by the foreign corporation determined without taking into account whether the domestic corporation is a RIC or REIT. §245A(c)(3). No foreign tax credit under section 901 or deduction is allowed under §164 for any foreign taxes paid or accrued on a dividend qualifying for the section 245A DRD. The section 245A DRD does not apply, however, to any dividend received by a US shareholder from a CFC if the dividend is a “hybrid dividend”. §245A(e)(1). A hybrid dividend is an amount received from a CFC: (i) for which a DRD would be allowed under section 245A(a); and (ii) for which the CFC received a deduction (or other tax benefit) with respect to any tax imposed by any foreign country or possession of the US. §245A(e)(4). With respect to tiered corporations, where a CFC receives a hybrid dividend from another CFC with respect to which such domestic corporation is also a US shareholder, then, the hybrid dividend is treated as subpart F income under section 951(a)(1)(A) of the receiving CFC for the taxable year the dividend was received and the US shareholder is required to include in gross income as subpart F income.
Under section 245A(g), Congress provided the Treasury and the Service the ability to issue legislative regulations and/or other guidance as may be necessary or appropriate to carry out the provisions of section 245A, including the treatment of US shareholders of a specified 10% owned foreign corporation. The temporary regulations reflect the width and breadth of the rule-making authority of the Treasury under section 245A.
Section 245A is part of an integrated set of provisions that includes subpart F, the repatriation rule in section 965 as well as the GILTI rule in section 951A. As to the last item, GILTI, which was also enacted into law by the TCJA 2017, is applied in tandem in certain instances with the 50% deduction rule contained in section 250(a)(1)(B). It is the recently enacted sibling of section 951(a)(1), which requires the pass through of subpart F income to US shareholders of a CFC. In a parallel fashion, GILTI requires US shareholders of a CFC’s active business income, to be subject to current taxation on their pro rata share of off-shore profits whether distributed or not.
GILTI is the acronym for “global intangible low-taxed income” but the reference to “intangible” is somewhat misleading. The required inclusion of GILTI is essentially active business income which is otherwise not described as subpart F income of a CFC. The CFC’s U.S. shareholders are subject to current U.S. tax on the CFC’s income in excess of the CFC’s normal return, potentially at a reduced rate through a deduction under section 250, at the corporate U.S. shareholder level. A portion of the GILTI amount is eliminated to the extent of 10% of the asset basis of the CFC which reflects the difference between the actual “higher” rate of return on assets in use versus the “normal” rates of return on assets. The notion is somehow rationalized on base erosion concepts but it is hardly convincing. The GILTI regime applies in the first taxable year of a CFC beginning on or after January 1, 2018. Section 245A applies to distributions made by SFCs (which include CFCs) on or after that date.
Another related provision is the previously taxed income rule under section 959 for subpart F income that was previously included in gross income (PTEP). Now PTEP has been expanded to take into account income inclusions under the GILTI rules under section 951A as well as under section 965 pertaining to the recapture of the accumulated (CFC) foreign E&P. A dividend sourced from PTEP under section 959 may not qualify as a 100% DRD under section 245A. Section 959 distributions are generally not taxable anyway. Therefore, after section 959 is taken into account, only residual earnings remaining after the potential application of sections 951(a)(1)(subpart F income), 951A (GILTI), and 965 (transition distributions) are eligible for the section 245A deduction.
That is, section 245A(a) applies only to certain “dividends” received from foreign corporations. Sections 951(a), 951A, and 965 generally have priority over section 245A because, when they apply to a foreign corporation’s earnings, distributions of those earnings do not qualify as dividends under section 959(d), and, therefore, section 245A does not apply. Non-CFC status allows a 10% U.S. shareholder that is a domestic corporation, to benefit directly from not being subject to US tax under subpart F or GILTI subject to the provisions of the temporary regulations or as may otherwise be provided.
Section 954(c)(6), enacted into law in 2005 as part of the foreign base company income rules, provides that intragroup foreign-to-foreign dividends, rents, interest and royalties, etc., accrued or paid by one CFC to another related CFC are not included in foreign personal holding company income to the extent attributable to income of the related person which is neither subpart F income nor is effectively connected with the conduct of a US trade or business.
Temporary Regulations In General Under Section 245A
The Preamble provides a comprehensive description of the temporary rule-making. The first point made is that section 245A can not be applied in a vacuum. It is part of a set of “closely integrated” rules with respect to earnings of foreign corporations for which there are one or more US shareholders. What is again important to understand is that the door to the participation exemption doesn’t open where income is required to be passed through under the subpart F or GILTI provisions. Therefore, section 245A is a residual type provision which applies to earnings which are not subpart F income, not includible as GILTI or is otherwise excluded under section 965.  Section 245A can only apply to dividends that fall outside of those three provisions and is not a PTEP distribution. There may be uncertainty if not confusion where a CFC’s taxable year is different than the US shareholder’s. The overarching theme to the temporary regulations is that section 245A was not intended to override or in any way defeat the purposes of the subpart F and GILTI provisions. The legislative regulations under section 245A(g) acknowledge that Congress expected the Treasury and its delegate to provide clear markers and rules in this area. Therefore, the temporary regulations will deny application of section 245A DRD where to allow the exemption would defeat the purpose of the subpart F or GILTI rules. Similarly, the temporary regulations acknowledge the need to address section 954(c)(6) which may also be used in a manner to avoid taxation of income that would be includible under GILTI or subpart F income. This issue can arise outside of the section 245A context of course. 
Limit on Amount of Section 245A Deduction: The Treasury is Definitely Concerned About “Gaming Transactions” Between Related CFCs During the So-Called “Disqualified Period” And Beyond
Extraordinary Disposition Amounts
In order to qualify under section 245A, Temp. Reg. §1.245A-5T(b) provides, in general, that the dividend must not be an “ineligible amount”. An “ineligible amount” is the sum of: (i) 50% of the portion of a dividend attributable to certain E&P resulting from transactions between related parties after the measurement date in section 965(a)(2) and in which the specified foreign corporation was a CRC but during which section 951A did not apply to it (“the extraordinary disposition amount”); and (ii) the portion of a dividend sourced from E&P generated for tax years ending after December 31, 2017 in which the domestic corporation reduced its ownership of the CFC (“the extraordinary reduction amount”). The government’s concern in this area is that during the “disqualified period” between the last day of a CFC’s tax year starting in 2017 and the commencement of its exposure to section 951A, CFCs may have engaged in transactions with related parties where, for example, it was desired to have a stepped-up basis for the buyer while generating earnings and profits for the seller CFC that are not subject to any current tax and may further be eligible for the section 245A deduction. This type of transaction is designed to avoid subpart F and would have been effectuated during the so-called “disqualified period”. In such case, the argument would be that such transactions are not subject to US tax under sections 965, 951(a)(1)(subpart F) or 951A (GILTI). Where E&P is produced by the related CFC parties, could reduce taxable gain under section 1248 on the subsequent taxable disposition of the CFC. The concern of course is that such earnings would avoid any US tax.
The temporary regulations, limit in certain prescribed instances, the amount of the section 245A DRD to an eligible shareholder (see Temp. Reg. §1.245A-5T(i)(21)) for a dividend received from a specified foreign corporation to 50% of the extraordinary disposition amount. A set of new definitions are contained in the regulations. The extraordinary disposition amount for this purpose is the portion of a dividend received by a section 245A shareholder from an specified foreign corporation that is paid out of the section 245A shareholder’s “extraordinary disposition account.” See Temp. Regs. §§1.245A-5T(b)(2) and (c)(1). The “extraordinary disposition account” of a US shareholder (domestic corporation) is its pro rata share of the specified foreign corporation’s “extraordinary disposition E&P,” reduced by the section 245A shareholder’s prior extraordinary disposition amounts, if any. See Temp. Reg. §1.245A-5T(c)((3)(i)(C)(1)). Extraordinary disposition E&P is an amount equal to the earnings of an specified foreign corporation arising from gain recognized by reason of one or more “extraordinary dispositions.” See Temp. Reg. §1.245A-5T(c)(3)(i)(C). Sounds quite simple doesn’t it?
To make this most complex set of rules more understandable if not coherent, the Preamble summarizes this limitation on section 245A as follows:
“The section 245A deduction is limited to 50 percent of the extraordinary disposition amount to reflect the fact that taxpayers generally would have been eligible for a deduction under either (i) section 250(a)(1)(B) had section 951A applied to the SFC [specified foreign corporation] during the disqualified period or (ii) section 965(c) had the net gain been subject to the transition tax under section 965.
For a disposition by an SFC [specified foreign corporation] to be an extraordinary disposition, the disposition must (i) be of specified property (defined in §1.245A-5T(c)(3)(iv) as any property other than property that produces gross income described in section 951A(c)(2)(A)(i)(I) through (V)), (ii) occur during the SFC’s [specified foreign corporation’s] disqualified period (as defined in §1.245A-5T(c)(3)(iii)) and when the SFC [specified foreign corporation] was a CFC, (iii) be outside of the ordinary course of the SFC’s [specified foreign corporation’s] activities, and (iv) be to a related party. See §1.245A-5T(c)(3)(ii). For these purposes, a disposition by an SFC [specified foreign corporation] includes certain indirect dispositions by the SFC through a partnership or other pass-through entities (including through ownership structures involving tiered pass-through entities).”
There is a de minimis rule in the temporary regulations that saves us from this “extraordinary” limitation on the section 245A deduction. No dispositions by a specified foreign corporation otherwise considered to be an extraordinary disposition will not be so treated if they do not exceed the lesser of $50 million or 5% of the gross value of the specified foreign corporation’s property. See Temp. Reg. §1.245A-5T(c)(3)(ii)(E). While $50,000,000 is not a small number, the idea that 5.1% puts the entire amount in the section 245A reduction machine is somewhat disappointing and really does look to be a “de minimis” rule. In fact, a slightly underpriced transaction between related CFCs can fall outside of the “de minimis” rule’s application.
The temporary regulations further provide that a facts and circumstances test will be applied in determining whether a particular disposition is outside of the ordinary course of the specified foreign corporation’s business activities. There is more. The temporary regulations also provide a per se rule, not a safe harbor mind you, that a disposition will be treated as outside of the ordinary course of a specified foreign corporation’s activities where the disposition has “a” principal purpose the generation of earnings and profits during the disqualified period or is the disposition of intangible property within section 367(d)(4). The latter rule accounts for the perception of the Treasury that the disposition of intangible property is not an ordinary course transaction, and that during the disqualified period taxpayers presumably had a strong incentive to dispose of low basis intangibles to generate substantial amounts of earnings and profits without being subject to current US taxation and that may be designed to qualify for the 100% DRD under section 245A.
The Preamble then “softens” a bit by stating that not all earnings and profits generated by a CFC during the disqualified period will be subject to the extraordinary disposition rules.
Tracking rules for extraordinary dispositions determined on a per US shareholder basis are set forth in the temporary regulations. See Temp. Reg. §1.245A-5T(c)(3)(i). There are also successor in stock interest rules for extraordinary dispositions as well as application of these rules to transactions described in sections 354-356 as well as under the tax attribution rules in section 381. See Temp. Reg. §1.245A-5T(c)(4).
Comments were requested on the application of the extraordinary disposition account rules should apply where a specified foreign corporation is transferred to a partnership, and whether principles under section 704(c)(1)(B) should apply to prevent the circumvention of the temporary regulations where a specified foreign corporation is subsequently transferred to a non-contributing partner. Further comments were requested on the application these rules for consolidated groups. See single taxpayer rule in Temp. Reg. §1.245A-5T(c). 
Extraordinary Reduction Amounts
The government is also concerned about “games” being played to access section 245A beyond the “disqualified period” which has already expired where a shareholder of a CFC transfers stock of the CFC or other instances where the shareholder’s ownership of the CFC is diluted. Such transfers may result in improper tax avoidance by end running the integrated structure of the US international tax system for CFC earnings under subpart F and GILTI. The idea is for US shareholders to reduce or eliminate the pass through of subpart F income or GILTI. Transactions in this area go well beyond the “disqualified period” for extraordinary dispositions discussed previously.
Under section 951(a)(2)(B), under the subpart F rules, double taxation of the same earnings attributable to subpart F income by reducing a US shareholder’s pro rata share of subpart F income (or “tested income” under GILTI per section 951A(c)(2)(A)) of a CFC by dividends received by another person with respect to the same share of stock.
The Preamble to the rule-making comments that were section 245A to apply without limitation to dividends from a CFC that reduce another US shareholder’s pro rata share of subpart F income or GILTI tested income, such earnings reduction would avoid US taxation to such extent. Another example is the sale of CFC stock from one section 245A shareholder to another. In such instance a deemed dividend resulting by application of section 1248 may be excluded from the seller’s income under section 245A while the purchaser’s pro rata share of subpart F income or GILTI tested income may be reduced under section 951(a)(2)(B). The Treasury does not want section 245A to be applied in tandem with a reduction in GILTI or subpart F income in such a transaction which would other result in “double non-taxation” of such income.
Under Temp. Regs. §§1.245A-5T(b)(1) and -5T(e), the section 245A DRD allowable to a “controlling section 245A shareholder” is limited to the amount of the dividend paid out of earnings other than the “extraordinary reduction amount”. A “controlling section 245A shareholder” of a CFC is one who owns, directly or indirectly, more than 50% of the stock of the CFC. Temp. Reg. §1.245-5T(i)(2). A controlling section 245A shareholder also includes an otherwise non-controlling shareholder who acts “in concert with the controlling section 245A shareholder”. This would include shareholders selling stock to the same buyer or buyers as part of the same plan as the controlling section 245A shareholder’s extraordinary reduction. A set of complex rules and examples are provided in the regulations.
The effect of an extraordinary reduction and therefore a limitation on the availability of the section 245A DRD will generally result in dividend income to the controlling section 245A shareholder not reduced by the section 245A deduction. In such instance the GILTI inclusion may look more advantageous to the deduction available under section 250. There is some good news. The temporary regulations provide an election under which a controlling 245A shareholder is not required to reduce its section 245A DRD where it elects to close the CFC’s taxable year for all purposes on the date of the extraordinary reduction. This results in the pass through of GILTI (and subpart F) income thereby eliminating application of section 245A. See Temp. Reg. §1.245A-5T(e)(3)(i). Other US shareholders presumably would have to agree for the closing of the books.
As with the extraordinary dispositions rule, there is a de minimis exception for a taxable year in which an extraordinary reduction occurs. In this regard, no amount is an extraordinary reduction amount where the sum of the CFC’s subpart F income and GILTI tested income for the taxable year does not exceed the lesser of $50 million or 5% of the CFC’s total income for the year. Temp. Reg. §1.245A-5T(e)(3)(ii).
The temporary regulations contain a set of coordination rules with respect to section 245A(e) on the hybrid dividend provision where it may overlap with an extraordinary disposition amount or extraordinary reduction amount.
Dividends Received By CFCs Ineligible for Section 245A Deduction
As mentioned, section 245A only applies to certain dividends received by a US “domestic corporation”. Under Treas. Reg. §1.952-2, in certain instances a foreign corporation is treated as a domestic corporation in determining gross income and taxable income. The question is whether section 245A applies in such instances. The legislative history to section 245A provides that it does not. H.R. Rep. No. 115-466, 599, fn. 1486 (2017). Forthcoming guidance will be provided by the Treasury and the Service in this area. The government is of the view, however, that in no case would any person, including a foreign corporation, be allowed a section 245A deduction directly or indirectly for the portion of a dividend paid to a CFC that is not eligible for the section 954(c)(6) exception as a result of the temporary regulations.
The temporary regulations under section 245A apply for distributions occurring after December 31, 2017. As to section 954(c)(6) provisions in the rule-making, such also apply to distributions occurring after December 31, 2017 subject to a transition rule for determining tiered extraordinary reduction amounts in Prop. Reg. §1.245A-5T(f)(3).
While the integration of the subpart F, GILTI, repatriation and section 245A DRD rules were satisfactorily addressed in the temporary regulations, the concerns reflected in the “extraordinary” rules in an effort to police so-called extraordinary dispositions and extraordinary reduction amounts will not be good news for those having to retrace their footsteps already taken and in planning in this area in the future. In addition, the tag-along rules for denying unlimited access to section 245A between controlling and non-controlling section 245A shareholders also seems a bit extreme. Looking at the rule-making, the government is convinced that various “shell” type games have already been played and will continue to be undertaken to exploit the participation exemption section 245A. While such concern is fair, the question becomes whether these regulations go too far. Perhaps the de minimis standards of 5% can be increased to 10% or even 15% to make a greater set of transactions less suspect and capable of setting the goal posts that are relatively certain and fixed.
Stay tuned. There is definitely more to follow.
This post was intended to be published for informational purposes only and may not be relied upon by the reader or any other person as legal advice of Fox Rothschild LLP or the lawyer posting this information. Persons reading this post should consult with their own tax counsel or tax adviser in order to be advised on the subject of the participation exemption under Code Section 245A and set of integrated tax rules enacted into law as part of the Tax Cuts and Jobs Act of 2017 described in the Temporary Regulations discussed in this post.
Please feel free to contact, however, your lead attorney in Fox Rothschild LLP or the Jerry August of Fox Rothschild LLP if you have a question or comment on this subject.
 Examples of countries having such exemptions are Luxembourg, Switzerland and Denmark.
 Corrections were made on August 8, 2019 to the T.D. 9865. See 84 FR 38866.
 In allowing the 100% DRD participation exemption under §245A, Congress forced the deemed repatriation of all foreign accumulated earnings and profits (non-previously distributed subpart F income) since 1986 to be included in gross income for taxable years starting in 2017 in accordance with §965. The required inclusion of previously accumulated foreign E&P stands in marked contrast to the benefit provided under §245A which applies only to US domestic shareholders owning 10% of the stock of a specified foreign corporation.
 Under §951A(b)(1), “global intangible low-taxed income” means, with respect to any US shareholder for any taxable year of such shareholder, the excess (if any) of (i) such shareholder’s net CFC tested income per §951A(c) over (ii) such shareholder’s net deemed tangible income return.
 See §959(c) which sets forth ordering rules that treat PTEP distributions as having priority and §959(d) which provides that a distribution of PTEP to a US shareholder is not treated as a dividend. See also §951A(f)(1)(A).
 See §245(c)(3).
 See Notice 2007-9, 2007-1 CB 401 (set forth guidance under §954(c)(6) as then was recently enacted including ant-avoidance rules).
 Comment was further requested on the application of the disqualified basis rules in Prop. Reg. §1.951A-2(c)(5) with Temp. Reg. §1.245A-5T(c).