Special Rule Regarding Certain Section 951 Pro Rata Share Allocations, 49894-49897 [05-16610]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 70, Number 164 (Thursday, August 25, 2005)]
[Proposed Rules]
[Pages 49894-49897]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-16610]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-129782-05]
RIN 1545-BE71


Special Rule Regarding Certain Section 951 Pro Rata Share 
Allocations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed amendments to regulations 
under section 951(a) of the Internal Revenue Code (Code) regarding a 
United States shareholder's pro rata share of a controlled foreign 
corporation's (CFC's) subpart F income, previously excluded subpart F 
income withdrawn from investment in less developed countries, and 
previously excluded subpart F income withdrawn from foreign base 
country shipping operations. These proposed regulations are intended to 
ensure that a CFC's earnings and profits for a taxable year 
attributable to a section 304 transaction will not be allocated in a 
manner that results in the avoidance of Federal income tax. These 
proposed regulations are also intended to ensure that earnings and 
profits of a CFC are not allocated to certain preferred stock in a 
manner inconsistent with the economic interest that such stock 
represents.

DATES: Written or electronic comments and requests for a public hearing 
must be received by October 24, 2005.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-129782-05), room 
5203, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-
129782-05), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the IRS 
Internet site at https://www.irs.gov/regs or via the Federal eRulemaking 
Portal athttps://www.regulations.gov (IRS and REG-129782-05).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,

[[Page 49895]]

Jefferson VanderWolk, (202) 622-3810; concerning submissions of 
comments and requests for a public hearing, Robin Jones, (202) 622-3521 
(not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    This document contains proposed amendments to 26 CFR part 1 under 
section 951(a) of the Code relating to the determination of a United 
States shareholder's pro rata share of a CFC's subpart F income, 
previously excluded subpart F income withdrawn from investment in less 
developed countries, and previously excluded subpart F income withdrawn 
from foreign base country shipping operations.
    In general, section 951(a)(1) requires a United States shareholder 
that owns stock in a CFC to include its pro rata share of such amounts 
in its gross income. Pro rata share is defined in section 951(a)(2) of 
the Code as the amount:
    (A) Which would have been distributed with respect to the stock 
which such shareholder owns (within the meaning of section 958(a)) in 
such corporation if on the last day in its taxable year on which the 
corporation is a [CFC] it had distributed pro rata to its shareholders 
an amount which bears the same ratio to its subpart F income for the 
taxable year, as the part of such year during which the corporation is 
a [CFC] bears to the entire year, reduced by
    (B) The amount of distributions received by any other person during 
such year as a dividend with respect to such stock, but only to the 
extent of the dividend which would have been received if the 
distribution by the corporation had been the amount which bears the 
same ratio to the subpart F income of such corporation for the taxable 
year, as the part of such year during which such shareholder did not 
own (within the meaning of section 958(a)) such stock bears to the 
entire year.
    A CFC's earnings and profits are allocated among different classes 
of the CFC's stock for the purpose of determining the pro rata share of 
the CFC's subpart F income or withdrawal of previously excluded subpart 
F income of a United States shareholder of such CFC under Sec.  1.951-
1(e). The IRS and Treasury Department are aware of certain transactions 
in which a CFC's earnings and profits and subpart F income for a 
taxable year are increased by a deemed dividend arising from a 
transaction described in section 304, with respect to which taxpayers 
take the position that the current regulations permit the allocation of 
earnings and profits between different classes of stock (e.g., common 
stock and preferred stock) in a manner inconsistent with the economic 
interests in the CFC represented by the respective classes of stock. 
The IRS and Treasury Department believe that such allocations are 
inconsistent with the policies underlying subpart F. These proposed 
regulations would provide additional guidance to ensure results that 
are consistent with such economic interests.
    Responding to regulations proposed under section 951 on August 6, 
2004, and published in final form in this issue of the Federal Register 
(REG-129771-04), a commentator observed that U.S. shareholders of CFCs 
sometimes have caused mandatorily redeemable preferred stock with 
cumulative dividend rights to be issued to (or otherwise acquired by) 
foreign persons. Relying on the fact that the hypothetical distribution 
rule does not take into account the time value of money, the parties in 
these transactions provide a relatively high dividend rate on such 
stock but forego compounding on the accrued but unpaid dividends, which 
would generally be required in an arms' length transaction. This would 
inappropriately deflect subpart F income inclusions with respect to the 
U.S. shareholder's stock in the CFC. To address this concern, the 
proposed regulations provide a special allocation rule for such stock 
which would appropriately discount the amount of earnings and profits 
allocated to the preferred stock in annual hypothetical distributions.

Explanation of Provisions

A. Earnings and Profits From Certain Section 304 Transactions

    Section 1.951-1(e) defines pro rata share for purposes of section 
951(a) of the Code. Proposed Sec.  1.951-1(e)(3)(v) adds a special rule 
that would modify the general rule of Sec.  1.951-1(e)(3)(i) regarding 
the allocation of a CFC's current earnings and profits to more than one 
class of stock. The general rule provides for the allocation of current 
earnings and profits to different classes of stock on the basis of the 
respective amounts of such earnings and profits that would be 
distributed with respect to each class if such earnings and profits 
were distributed on the last day of the CFC's taxable year on which it 
is a CFC.
    The special rule applies where a CFC has earnings and profits and 
subpart F income for its taxable year attributable to a transaction 
described in section 304 of the Code and that transaction is part of a 
plan a principal purpose of which is to avoid Federal income taxation 
by allocating the subpart F income resulting from the section 304 
transaction disproportionately to a tax-indifferent party. Pursuant to 
the rule, such earnings and profits will be allocated to each class of 
stock of the CFC in accordance with the value of such class relative to 
all other classes.
    In the absence of the special rule, the current earnings and 
profits of a CFC having a class of preferred stock with a fixed return 
and a class of common stock would be allocated under the general rule 
on the basis of a hypothetical distribution. Thus, the preferred stock 
would receive an allocation equal to the amount of the fixed return on 
the total investment in such stock, and the common stock would receive 
an allocation of the remainder of the earnings and profits. This result 
would not reflect the actual economic interest in the CFC of the 
respective classes of stock in a case where the earnings and profits 
were artificially inflated as a result of the dividend arising from the 
section 304 transaction. The amount allocated to the preferred stock in 
such a case under the general rule would be a significantly smaller 
percentage of the total than the percentage of the corporation's value 
represented by the preferred stock.
    This is illustrated by the example that would be added to Sec.  
1.951-1(e)(6) by these proposed regulations. By modifying the 
allocation of earnings and profits to classes of stock in this limited 
category of cases, the proposed regulations ensure that the allocation 
will be consistent with the economic interest in the CFC represented by 
the respective classes of stock.

B. Certain Cumulative Preferred Stock

    Proposed Sec.  1.951-1(e)(4)(ii) would add a special rule that 
would determine the hypothetical distribution of earnings and profits 
with respect to cumulative preferred stock with a mandatory redemption 
date by reflecting the present value of accrued but unpaid dividends 
with respect to such stock, determined generally on the basis of the 
implied annual rate of return on such stock and the length of time 
between the current year's hypothetical distribution date and the 
mandatory redemption date. This special rule would apply only if the 
rate of compounding on the accrued but unpaid cumulative dividends 
would be less than the appropriate applicable Federal rate and if a 
distribution on the stock would not be included in the gross income of 
a United States taxpayer.

[[Page 49896]]

Proposed Effective Dates

    Sections 1.951-1(e)(3)(v) and 1.951-1(e)(4)(ii) are proposed to 
apply for taxable years of a controlled foreign corporation beginning 
on or after January 1, 2006.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations and because 
these regulations do not impose a collection of information on small 
entities, a Regulatory Flexibility Analysis under the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to 
section 7805(f) of the Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Requests for Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and Treasury Department specifically request comments 
regarding appropriate rules for determining under section 951 the 
hypothetical distribution of earnings and profits for cumulative 
preferred stock that does not have a mandatory redemption date, or that 
is subject to a shareholder-level agreement, such as a purchase option, 
to take into account the present value of accrued but unpaid dividends. 
The IRS and Treasury Department contemplate that if promulgated, such 
rules would be effective for taxable years of a controlled foreign 
corporation beginning on or after January 1, 2006.
    The IRS and Treasury Department also request comments on the 
clarity of the proposed rules and how they can be made easier to 
understand. All comments will be available for public inspection and 
copying. A public hearing will be scheduled if requested in writing by 
any person who timely submits written comments. If a public hearing is 
scheduled, notice of the date, time, and place of the hearing will be 
published in the Federal Register.

Drafting Information

    The principal author of these regulations is Jefferson VanderWolk 
of the Office of the Associate Chief Counsel (International). However, 
other personnel from the IRS and Treasury Department participated in 
their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAXES

    Par. 1. The authority citation for part 1 continues to read, in 
part, as follows:

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

    Par. 2. Section 1.951-1 is amended by revising paragraphs 
(e)(3)(v), (e)(4)(ii), (e)(6) Example 9, and (e)(7).
    The revisions read as follows:


Sec.  1.951-1  Amounts included in gross income of United States 
shareholders.

* * * * *
    (e) * * *
    (3) * * *
    (v) Earnings and profits attributable to certain section 304 
transactions. For taxable years of a controlled foreign corporation 
beginning on or after January 1, 2006, if a controlled foreign 
corporation has more than one class of stock outstanding and the 
corporation has earnings and profits and subpart F income for a taxable 
year attributable to a transaction described in section 304, and such 
transaction is part of a plan a principal purpose of which is the 
avoidance of Federal income taxation, the amount of such earnings and 
profits allocated to any one class of stock shall be that amount which 
bears the same ratio to the remainder of such earnings and profits as 
the value of all shares of such class of stock, determined on the 
hypothetical distribution date, bears to the total value of all shares 
of all classes of stock of the corporation, determined on the 
hypothetical distribution date.
    (4) * * * (i) * * *
    (ii) Certain cumulative preferred stock. For taxable years of a 
controlled foreign corporation beginning on or after January 1, 2006, 
if a controlled foreign corporation has one or more classes of 
preferred stock with a mandatory redemption date and cumulative 
dividend rights, arrearages on which compound at a rate less than an 
annual compounding at the applicable Federal rate (as defined in 
section 1274(d)(1)) (AFR) that applies on the date the stock is issued 
for the term from such issue date to the mandatory redemption date, 
then, to the extent that--
    (A) A distribution with respect to such stock on the hypothetical 
distribution date would not be includible in the gross income of a 
citizen or individual resident of the United States, a domestic 
corporation, or a foreign person as income effectively connected with 
such foreign person's conduct of a trade or business in the United 
States; and
    (B) Any dividends accruing with respect to such stock during the 
taxable year of the controlled foreign corporation have not been paid 
during such taxable year (accrued but unpaid dividends), the amount of 
earnings and profits that shall be considered to be distributed as part 
of the hypothetical distribution for purposes of paragraph (e)(3)(i) of 
this section with respect to such stock shall be equal to the present 
value of such accrued but unpaid dividends for the taxable year. The 
present value of such accrued but unpaid dividends for the taxable year 
is determined for the purposes of this paragraph by discounting such 
accrued but unpaid dividends for that taxable year from the mandatory 
redemption date to the hypothetical distribution date using the implied 
annual rate of return on an investment at par in a share of such stock 
that is held from the date of issue until the mandatory redemption 
date, on the assumption that no dividends with respect to the stock are 
paid prior to redemption.
* * * * *
    (6) * * *
    Example 9. (i) Facts. In 2006, FC10, a controlled foreign 
corporation within the meaning of section 957(a), has outstanding 
100 shares of common stock and 100 shares of 6-percent, voting, 
preferred stock with a par value of $10x per share. All of the 
common stock is held by Corp H, a foreign corporation which invested 
$1000x in FC10 in exchange for the common stock. All of FC10's 
preferred stock is held by Corp J, a domestic corporation which 
invested $1000x in FC10 in exchange for the FC10 preferred stock. 
The value of the common stock of FC10 at all relevant times is 
$1000x and the value of the preferred stock of FC10 at all relevant 
times is also $1000x. In 2006, FC10 borrows $3000x from a bank and 
invests $5000x in preferred stock issued by FC11, a foreign 
corporation owned by Corp J. FC11, which has no current or 
accumulated earnings and profits, uses the proceeds to lend $5000x 
to Corp J. In 2008, FC10 sells the FC11 preferred stock to FC12, a 
wholly owned foreign subsidiary of FC11 that has $5000x of 
accumulated earnings and profits, for $5000x in a transaction 
described in section 304. FC10 repays the bank loan in full. The 
acquisition and sale of the FC11 preferred stock by FC10 was part of 
a plan a principal purpose of which was the avoidance of Federal 
income tax. For 2008, FC10 has $5000x of earnings and profits, all 
of which is subpart F income attributable to

[[Page 49897]]

a deemed dividend arising from FC10's sale of the FC11 preferred 
stock to FC12.
    (ii) Analysis. FC10 has $5000x of earnings and profits for 2008 
attributable to a dividend from a section 304 transaction which was 
part of a plan a principal purpose of which was the avoidance of 
Federal income taxation. Under paragraph (e)(3)(v) of this section, 
these earnings and profits are allocated to the common and preferred 
stock of FC10 in accordance with the relative value of each class of 
stock. Thus, for taxable year 2008, $2500x is allocated to FC10's 
common stock and $2500x is allocated to its preferred stock.

    (7) Effective dates. Except as provided in paragraphs (e)(3)(v) and 
(e)(4)(ii) of this section, this paragraph (e) applies for taxable 
years of a controlled foreign corporation beginning on or after January 
1, 2005. * * *
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 05-16610 Filed 8-24-05; 8:45 am]
BILLING CODE 4830-01-P