Advising International Business Ventures: Tax Reform’s Section 245A Participation Exemption Regime

In International Tax, Tax Reform by Jason FreemanLeave a Comment

Freeman Law frequently advises international business ventures. International operations often give rise to unique (and sometimes unanticipated) compliance obligations and complex reporting requirements. Recent tax reform rules and regulations have imposed a number of new requirements.  The IRS and Treasury Department have elaborated on these new rules through proposed regulations and other guidance.  This post focuses on, and provides a short introduction to, the new section 245A Participation Exemption System.

 

The Tax Cuts and Jobs Act, Pub. L. 115- 97 (2017) (“the TCJA”) enacted new section 245A, which provides for the new Participation Exemption System and a dividends received deduction (“DRD”) for certain foreign-source income—a central part of the new international tax regime.  Section 245A is an integral part of the TCJA’s changes to the international tax regime, which largely adopt a quasi-territorial tax system for foreign-source income earned by foreign subsidiaries of certain domestic corporations.

The TCJA’s “participation exemption” under Section 245A generally exempts a dividend received by a 10%-or-greater U.S. corporate shareholder of a foreign subsidiary from tax.  More technically, under new section 245A(a), a domestic corporation that is a U.S. shareholder of, and that receives a dividend from, a “specified 10-percent owned foreign corporation” is allowed as a deduction equal to the foreign-source portion of that dividend. A “specified 10-percent owned foreign corporation” is defined in section 245A(b) as any foreign corporation (other than certain passive foreign investment companies) with respect to which a domestic corporation is a U.S. shareholder.

Section 245A’s “participation exemption” is a key feature in the TCJA’s new international tax regime.  It applies where the domestic corporate shareholder owns directly, indirectly, or by attribution, 10% or more of the voting power or value of the foreign corporation.  (It does not, however, apply with respect to a foreign corporation that is a passive foreign investment company (“PFIC”) that is not a controlled foreign corporation (“CFC”).).

The “foreign-source portion” of a dividend is the amount that bears the same ratio to the dividend as the “undistributed foreign earnings” bear to the “undistributed earnings” of the “specified 10-percent owned foreign corporation.”  Undistributed foreign earnings are undistributed earnings that are not effectively connected with the conduct of a trade or business within the United States (“ECI”) or dividends received from a domestic corporation that is at least 80% owned, directly or indirectly, by the specified 10-percent owned foreign corporation.

Hybrid dividends, Holding-Period Requirements, and Contractual Arrangements that Diminish Risk of Loss.  The participation exemption is not available with respect to “hybrid” dividends, and is generally not available unless the domestic corporation has held the stock for more than 365 days during the 731-day period that begins 365 days before the ex-dividend date.  The period during which the taxpayer held certain contractual arrangements that diminish the taxpayer’s risk of loss with respect to the foreign subsidiary’s stock, including an option to sell, short sale, granting an option to buy substantially similar stock or securities, or other events prescribed under regulations, do not count towards this holding period.

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