New Rules Expand Circumstances Requiring Current Inclusions of Controlled Foreign Corporation’s Income: IRS Issues Temporary and Proposed Regulations Regarding When a Controlled Foreign Corporation’s Partnership Transactions Will Result in Current Taxable Income for United States Shareholders and Temporary Regulations Expanding the Requirement That a Controlled Foreign Corporation Earn Active Rents and Royalties Through Its Own Officers and Employees

Sullivan & Cromwell LLP - September 21, 2015

While a United States shareholder of a foreign corporation generally is not required to include its share of a foreign corporation’s earnings in income until distributed, there are a number of exceptions to such deferral.  One exception to deferral applies when the foreign subsidiary makes an investment in certain United States property (generally equity or debt of a related United States entity).  The IRS issued proposed regulations (the “956 Proposed Regulations”) that treat an obligation of a foreign partnership (subject to certain exceptions) as an obligation of its partners (and thus as an obligation of any United States partner of the foreign partnership) to the extent of each partner’s share of the obligation determined in accordance with the partner’s interest in partnership profits.  By contrast, the 956 Proposed Regulations confirm that an obligation of a domestic partnership is an obligation of a United States person (and thus, subject to certain exceptions, United States property requiring an inclusion in income), even if the partnership has foreign partners.  The 956 Proposed Regulations also include an anti-abuse rule for partnership distributions funded by a CFC.  Additionally, the 956 Proposed Regulations provide that a CFC partner in a partnership that holds United States property would generally be allocated a portion of such property in accordance with its share of the liquidation value of the partnership, taking into account special allocations.  In addition, the 956 Proposed Regulations modify and extend to transactions involving partnerships the current rules regarding direct or indirect pledges and guarantees.  The 956 Proposed Regulations would generally be effective only when finalized but, after such date, would generally apply with respect to obligations acquired, or pledges or guarantees entered into, on or after September 2, 2015.

The IRS also issued temporary regulations (the “956 Temporary Regulations”) that broaden the application of an anti-avoidance rule with respect to indirect investments in United States property by a CFC, including through partnerships and, similar to the 956 Proposed Regulations, provide a special rule for foreign partnership distributions funded by CFCs.  The 956 Temporary Regulations generally apply to periods after September 2, 2015.

Additional temporary regulations (the “954 Temporary Regulations”) expand the requirement by a CFC to perform activities through its own officers or employees in order to qualify for the active rents and active royalties exceptions to current inclusion treatment (i.e., active rents and royalties earned by a CFC benefit from deferral and do not need to be included in income by the CFC’s United States shareholders until distributed).  In addition, a CFC that makes payments to a controlled party pursuant to a cost-sharing arrangement will not be treated as earning active income by virtue of the activities of the controlled party’s officers and employees.  The 954 Temporary Regulations generally apply to rents and royalties received or accrued during periods after September 2, 2015.