Regulations: “United States property,” foreign partnerships, active rents and royalties

Subpart F regulations, "United States property"

The Treasury Department and IRS today released for publication in the Federal Register temporary regulations (T.D. 9733), and proposed regulations (REG-155164-09) addressing a number of issues in the “Subpart F” regime applicable to controlled foreign corporations (CFCs) and the United States shareholders (USSH) thereof. The discussion below contains high-level summary of the temporary and proposed regulations, based upon an initial review, and will be supplemented with further analysis in the future.


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In general, the temporary regulations [PDF 236 KB] will apply to:


  • CFC acquisitions of “United States Property,” (U.S. Property) certain partnership distributions, and certain transactions involving rents and royalties that occur on or after September 2, 2015
  • Tax years of CFCs that end after such date; and to the tax years of the CFCs’ USSHs that end with or within the CFC’s years 

The rules also explicitly state that for investments in U.S. Property, a deemed exchange pursuant to section 1001 (for example, a substantial modification of a debt instrument under Reg. section 1.1001-3) constitutes a new acquisition of the property.

Temporary regulations: CFC provisions

Anti-abuse rule changes

The temporary regulations modify the section 956 “anti-abuse” rule in Reg. section 1.956-1T(b)(4) in several key respects. The current version, which generally applies to treat one CFC as holding property actually held by another CFC when the former has “funded” the latter, was originally issued in 1988 and only applies to “funding” through capital contributions or debt.  The new rules would remove this restriction to provide that any funding (for example, distributions from one CFC to another) can trigger the anti-abuse rule.  In doing so, the provision has been made consistent with a parallel rule in the section 304 context (see Reg. section 1.304-4(b)(1)).  

New Reg. section 1.956-1T(b)(4) also includes a new example illustrating that a principal purpose of avoiding the application of section 956 to one CFC can be to access the tax attributes (such as foreign tax credit pools or previously taxed income accounts) of another CFC, as opposed to the mere avoidance of a section 956/951(a)(1)(B) income inclusion.  The IRS took a similar position in a Chief Counsel Advice (CCA) 201446020 issued last year. 

The new rule also clarifies that it applies to funding transactions between CFCs and partnerships controlled by the CFCs, and not strictly to transactions between CFCs. This addresses a perceived concern that taxpayers may have used partnerships to “dilute” the amount of a section 956 investment indirectly made by a CFC, and also formalizes a position taken by the IRS in recent CCA 201420017. 

Finally, the temporary regulations modify the anti-abuse rule to apply on a self-executing basis.  The prior version was technically based upon an affirmative application by the IRS.


Partnership distributions funded by CFCs

As discussed further below, the proposed regulations would holistically revise the treatment of loans made by CFCs to a foreign partnership when a USSH of the CFC is a partner in the partnership.  To address the issue on a shorter-term basis, new Reg. section 1.956-1T(b)(5) will treat a borrowing by a foreign partnership from a CFC as a “U.S. Property investment” by the CFC if the proceeds of the borrowing are distributed to a partner that is a related U.S. person of the CFC and the partnership would not have made the distribution but for the CFC’s funding of the partnership.


Active rents and royalties exception

Under current law, for a CFC to earn “active” rental or royalty income, the CFC must generally be engaged in an active business in the CFC’s country of incorporation.  The temporary regulations confirm that a CFC must meet the relevant activities test using the CFC’s own employees or staff.  There had been some ambiguity in this regard in certain situations under the current rules (cf. Reg. section 1.954-2(d)(3), Ex. 5). 

The temporary regulations next broaden the current rules to permit satisfying the active business tests by reference to more than one foreign jurisdiction and also including employees outside of the CFC’s country of organization.

Finally, the temporary regulations provide that payments made by a CFC to a related participant in a cost-sharing agreement (CSA) do not cause the CFC to be deemed to undertake the activities of the other participant for which the CFC is making the payment for purposes of the active development and active marketing tests.  Consistently, the CSA payments are not considered active leasing or licensing expenses under related rules.

Proposed regulations

The proposed regulations [PDF 328 KB] first-cross reference and include the temporary regulations, but also include several other substantive changes that are not included in the temporary regulations.

The proposed regulations are proposed to be effective for tax years of CFCs ending on or after regulations finalizing these rules are published in the Federal Register and for tax years of U.S. shareholders in which or with which the tax year ends. The preamble notes that most of these rules are proposed to apply to property acquired, or pledges or guarantees entered into on or after the date of filing at the Federal Register.

Comments and a request for a public hearing must be received within 90 days of September 2, 2015 (the date when the proposed regulations will be published in the Federal Register).


Debt of foreign partnerships

The proposed regulations contain a general rule that treats an obligation of a foreign partnership as an obligation of its partners for purposes of section 956.  This general rule is subject to an exception for obligations of foreign partnerships in which neither the lending CFC nor any person related to the lending CFC is a partner, which is consistent with the section 956(c)(2)(L) exception for obligations of domestic partnerships.

The partner’s share of the foreign partnership’s obligation would be determined according to the partner’s interest in the partnership’s profits, but the preamble requests comments as to whether the liquidation value percentage method or another method would be more appropriate.  A similar allocation rule applies when a CFC guarantees or otherwise pledges credit support for a partnership obligation and to the measurement of the section 956 U.S. Property investment when it is subject to a liability of the partnership.

The proposed regulations also include a special “tracing” rule when the partnership uses the proceeds of the loan from the CFC to make a distribution to a partner related to the CFC, but for which the CFC would not have made the distribution, and CFC’s loan would have been a section 956 investment to the partner. In this case, the amount of section 956 investment allocated to the partners will be the greater of the proceeds or their share under the profits interest approach.  When finalized, this rule would replace the interim provision on “but for” distributions by partnerships at Reg. section 1.956-1T(b)(5), discussed above.


Pledges and guarantees

Under current law, a U.S. Property investment by a CFC includes not only a CFC directly loaning money to a USSH but also providing direct or indirect credit support for the obligations of the USSH.  The proposed regulations would modify these “pledging” rules in several respects.

  • First, the rules confirm that the pledging or guaranteeing CFC is deemed to hold the obligation actually held by the USSH, with the result that any available exception to U.S. Property status for the obligation can apply.
  • Second, a pledge or guarantee by a CFC of an obligation of a foreign partnership is treated as a U.S. Property investment to the extent the obligation itself is attributed to a related U.S. person under the new partnership loan provision, discussed above.
  • Third, when a CFC is a partner in a partnership that pledges or guarantees the loan of a related U.S. person, the CFC generally will not be deemed to hold more than its share of the partnership’s obligation as otherwise determined under the proposed regulations.  
  • Fourth, the proposed regulations provide that a CFC that is a partner in a partnership will not be deemed to indirectly guarantee a partnership’s loan merely because the CFC partner is attributed a portion of the partnership’s assets under the proposed regulations. 
  • Finally, the preamble to the proposed regulations discusses the issue of “multiple” section 956 investments that may arise when more than one CFC pledges or guarantees an obligation of a related U.S. person.  The preamble notes this could lead to a greater overall U.S. income inclusion, from multiple CFCs with sufficient earnings and profits, than the outstanding principal amount of the obligation.  The preamble indicates that Treasury and the IRS are considering exercising their authority under section 956(e) to prevent multiple inclusions and propose several different allocation methods for this purpose. Implicit in the preamble’s discussion, however, is that the “multiple inclusion” result would occur under existing rules and in the absence of a special allocation method providing otherwise.  [See also IRS FSA 200216022, suggesting that nothing under current law would prohibit the multiple inclusion result].


Amount of partnership property held by a CFC partner

Current Reg. section 1.956-2(a)(3) provides that if a CFC is a partner in a partnership then the CFC owns a share of any U.S. Property investment owned by the partnership, based on the CFC’s interest in the partnership.  Under new proposed Reg. section 1.956-4(b), however, the CFC partner’s share will be determined under the “liquidation value percentage,” which takes into account any special allocation of income or gain from that property that is not disregarded or reallocated under section 704(b) or another rule.  The preamble suggests that while this method is only prospective for acquisitions of U.S. Property after the proposed regulations are finalized, reliance on it in the interim would be reasonable.

The preamble also requests comments on whether a single approach is to be used to determine a partner’s share of a partnership obligation as well as of other U.S. Property.


Trade or service receivables acquired from related U.S. persons

The current section 956 regulations address “factoring” transactions involving the acquisition of certain receivables by CFCs from related U.S. persons.  The proposed regulations would update the portion of these rules governing when property held by partnerships, or deemed held under the anti-abuse rule, is considered held by a CFC for purposes of the provision. 


Obligations of disregarded entities and domestic partnerships

The proposed regulations address questions of how obligations of a disregarded entity are taken into account for purposes of section 956. 

Newly proposed Reg. section 1.956-2(a)(3) [the current such provision relates to partnerships and will be renumbered in the finalization of Reg. section 1.956-4] provides that an obligation of a disregarded entity is an obligation of the disregarded entity’s tax owner for section 956 purposes.  The Treasury and IRS do not view this as a change from current law, because the result follows from application of the Reg. section 301.7701-3 entity classification rules.

The proposed regulations also confirm that an obligation of a domestic partnership is an obligation of a U.S. person for section 956 purposes as a general matter, unless an exception in section 956(c)(2) (such as section 956(c)(2)(L), discussed above) applies.


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