On October 2, 2019, Treasury and the IRS issued proposed regulations relating to the repeal of section 958(b)(4) by the Tax Cuts and Jobs Act (“TCJA”). On September 22, 2020, Treasury and the IRS issued final regulations largely following the proposed regulations, along with additional proposed regulations.
Prior to repeal under the TCJA, section 958(b)(4) provided a limitation on the application of the section 318 constructive ownership rules for purposes of determining whether a foreign corporation was a controlled foreign corporation (“CFC”) within the meaning of section 957. In particular, section 958(b)(4) turned off “downward attribution” from a foreign person to a U.S. person − for example, attribution from a foreign parent to a U.S. subsidiary. The TCJA repealed section 958(b)(4), increasing the number of foreign corporations that may be treated as CFCs as compared to prior law. For instance, consider a foreign parent (“FP”) that wholly owns a domestic subsidiary (“DS”), and together FP and DS wholly own a foreign subsidiary (“FS”). After the repeal of section 958(b)(4), FP’s stock in FS is attributed down to DS, such that FS is treated as a CFC with respect to DS. While the legislative history and prior case law would limit the consequences of such downward attribution in other contexts, the recent guidance contains no such limits.
Treatment of Portfolio Interest
Although section 958 is part of subpart F, the repeal of section 958(b)(4) affects numerous areas of the Code. In response, Treasury and the IRS issued proposed regulations on October 2, 2019, to ensure that the operation of certain rules outside of subpart F are consistent with their application before the repeal of section 958(b)(4). Notably absent from the proposed regulations were rules relating to the portfolio interest exception. The portfolio interest exception under section 881(c) exempts from tax under section 881(a) any U.S. source “portfolio interest” received by a foreign corporation. Very generally, portfolio interest includes interest paid on a debt obligation that is in “registered form” − i.e., where certain information about the debt and the noteholder are kept on record by the debt issuer. However, interest received by a CFC from a related person is specifically excluded from the definition of portfolio interest. Consequently, the repeal of section 958(b)(4) decreased the availability of the portfolio interest exception by increasing the number of foreign corporations treated as CFCs.
Comments submitted in response to the 2019 proposed regulations asked for relief for foreign corporations that are CFCs solely as a result of the repeal of section 958(b)(4). However, Treasury and the IRS declined to provide such relief, stating in the preamble to the final regulations that “[t]he rules set forth in the proposed regulations were all issued pursuant to specific grants of regulatory authority, and the Treasury Department and the IRS have determined that there is no statutory or regulatory authority to modify the limitation on the portfolio interest exception for payments received by CFCs from a related person.”
Other comments asked for “guidelines for withholding agents that might not be in a position to know whether a payee was affected by the repeal of section 958(b)(4).” Treasury and the IRS declined to issue a portfolio interest-specific rule, instead relying on the general standard of “actual knowledge or reason to know” under Treas. Reg. § 1.1441-7(b). Moreover, the preamble provides no guidance on the application of the “reason to know” standard in this context.
Relief Provided for Purposes of Chapter 61 Reporting
The final regulations finalize, as proposed, a rule providing relief with respect to domestic information reporting under Chapter 61. Generally, a “U.S. payor” must report to the IRS on Form 1099 certain payments to U.S. persons. The term “U.S. payor” is defined under Treas. Reg. § 1.6049-5(c)(5)(i) and generally includes U.S. persons and their foreign branches, as well as CFCs. To limit the expansion of information reporting under Chapter 61 by CFCs due solely to the repeal of section 958(b)(4), the final regulations limit the definition of U.S. payor to those CFCs that are not CFCs solely due to the repeal of section 958(b)(4).