For more than fifty years, and subject to many exceptions, U.S. shareholders have been utilizing the controlled foreign corporation (“CFC”) as a vehicle to defer U.S. tax liability on income earned abroad. Internal Revenue Code (“IRC”) § 957 defines a CFC as a corporation in which certain U.S. shareholders own more than 50% of said corporation. Generally speaking, by investing in a CFC, corporate shareholders are capable of deferring recognition of U.S. tax liability virtually indefinitely (subject to some exceptions, such as Subpart F Income recognition).
This virtually indefinite deferral of U.S. tax liability is possible because income earned by a CFC is taxable to its U.S. shareholders only at the time when the money is repatriated, or brought back to the United States, and not necessarily at the time the money is earned by the corporation.
Repatriation of income is accomplished in two ways: either through dividend distribution or effective dividend distribution (e.g., a transaction where the CFC makes a certain type of investment in U.S. property, such as corporate stock or real property). These distributions result in income, and subsequently, potential tax liability to the U.S. shareholder.
Prior to the enactment of the Tax Cut and Jobs Act (“TCJA”), IRC § 245, acting alone, allowed that a U.S. domestic shareholder in a CFC was entitled to a deduction only for the portion of a dividend distribution, or effective dividend distribution, which was attributable to U.S. source income. The U.S. corporate shareholder was required to pay tax on the portion of the dividend distribution that was attributable to foreign source income.
However, the TCJA added IRC § 245A, or the participation exemption system, as additional incentive for CFCs to repatriate foreign earnings. The exemption allows U.S. corporate shareholders of certain CFCs to deduct the foreign source portion of a dividend received from the shareholder’s gross income. This deduction is in addition to the I.R.C. § 245 dividends received deduction for the U.S. source portion of the dividend.
Thus, U.S. corporate shareholders effectively receive a one-hundred percent dividends received deduction for dividends from CFCs. This new system ultimately creates an opportunity for corporate shareholders to repatriate significant amounts of income, in the form of dividends or effective dividends, without paying any U.S. tax on it at all!
Keep in mind that local countries may charge a withholding tax on payment of dividends. Because there is no taxation in the U.S., this withholding will be an out-of-pocket cost. In prior years, typically withholding could be claimed as a foreign tax credit.
Note also that the IRS recently issued guidance regarding Section 956 and the participation exemption, treating deemed dividends under the IRC similar to actual repatriation and, to the extent the requirements are met, eligible for the participation exemption. We may see similar guidance issued with regard to all or some categories of Subpart F soon.