[Federal Register Volume 71, Number 35 (Wednesday, February 22, 2006)]
[Rules and Regulations]
[Pages 8943-8945]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 06-1532]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9251]
RIN 1545-BE71


Special Rules Regarding Certain Section 951 Pro Rata Share 
Allocations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final 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withdrawn from investment in less developed countries, and previously 
excluded subpart F income withdrawn from foreign base country shipping 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 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 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: Effective Date: These regulations are effective February 22, 
2006.
    Applicability Date: For dates of applicability, see Sec.  1.951-
1(e)(3)(v), (e)(4)(ii) and (e)(7).

FOR FURTHER INFORMATION CONTACT: Jefferson VanderWolk, (202) 622-3810 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On August 6, 2004, the IRS published in the Federal Register a 
notice of proposed rulemaking (REG-129771-04, 2004-36 I.R.B. 453) under 
section 951 of the Code. After consideration of comments received, the 
proposed regulations were modified and adopted as final with the 
publication of T.D. 9222 on August 25, 2005 (70 FR 49864). In response 
to comments, the IRS published at the same time in the Federal Register 
a notice of proposed rulemaking (REG-129782-05, 70 FR 49894) under 
section 951 of the Code. No written comments were received in response 
to that notice of proposed rulemaking. No public hearing was requested 
or held on the notice of proposed rulemaking. The proposed regulations 
are adopted as final regulations with the modifications discussed 
below.

Explanation of Changes

    Section 1.951-1(e) defines pro rata share for purposes of section 
951(a) of the Code. The general rule, set forth in Sec.  1.951-
1(e)(3)(i), 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.
    Section 1.951-1(e)(3)(v) provides a special rule that modifies the 
general rule regarding the allocation of a CFC's current earnings and 
profits to more than one class of stock. 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 are 
allocated to each class of stock of the CFC in accordance with the 
value of such class relative to all other classes.
    Several practitioners noted in oral comments that proposed Sec.  
1.951-1(e)(6), Example 9, which illustrates the application of proposed 
Sec.  1.951-1(e)(3)(v), presented facts whose characterization under 
other Code sections could be unclear under the circumstances. In 
response to these comments, the IRS and Treasury Department have 
revised the example in order to limit the issues presented.
    A comment on the rules originally proposed on August 6, 2004, 
requested guidance to eliminate inappropriate distortions between 
subpart F inclusions and economic realization that taxpayers may 
achieve if accumulated but unpaid dividends with respect to preferred 
stock are not discounted to present value for purposes of determining 
the hypothetical distribution. As a partial response to that comment, 
proposed Sec.  1.951-1(e)(4)(ii) provided a special rule requiring 
accumulated but unpaid dividends with respect to mandatorily redeemable 
cumulative preferred stock be taken into account at present value for 
purposes of the hypothetical distribution. Comments were requested 
regarding the treatment of 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. In addition, the preamble 
stated that the IRS and the Treasury Department anticipated that any 
such rules would be effective for taxable years of a controlled foreign 
corporation beginning on or after January 1, 2006. No further comments 
were received beyond the original comment.
    The IRS and Treasury Department agree with the commentator that 
accrued but unpaid dividends generally present possibilities for 
distortion between subpart F income inclusions and economic income 
realization. These distortions are similar to those that can arise from 
stock with discretionary

[[Page 8944]]

distribution rights. Accordingly, Sec.  1.951-1(e)(4)(ii) adds a rule 
that generally treats cumulative preferred stock with accrued but 
unpaid dividends in the same manner as stock with discretionary 
distribution rights (as defined in Sec.  1.951-1(e)(3)(ii)). Earnings 
and profits are allocated to such stock on the basis of the value of 
such stock relative to the value of other classes of stock outstanding.
    There are two exceptions to this general rule. First, to the extent 
that dividends are paid with respect to such stock during the year, 
earnings and profits equal to the amount of such dividends are first 
allocated to that class of stock. Additional earnings and profits are 
allocated to that class of stock only in the amount (if any) by which 
the value-based allocation of earnings and profits to that class of 
stock exceeds the amount of such dividends. Second, the final 
regulations preserve the special present-value rule (with technical 
modifications) for certain mandatorily redeemable cumulative preferred 
stock.
    Consistent with the comment received, and as provided in the 
preamble to the proposed regulations, these rules are effective 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, the notice of proposed rulemaking 
preceding these regulations was submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on its impact 
on small business.

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.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read, in 
part, as follows:

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

0
Par. 2. Section 1.951-1 is amended by revising paragraphs (e)(3)(v), 
(e)(4)(ii), and the first sentence of paragraph (e)(7), and paragraph 
(e)(6) Example 9 is added.
    The revisions and addition 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 cumulative dividend rights, such stock shall be 
considered for the purposes of this section as stock with discretionary 
distribution rights. As a result, the provisions of paragraph 
(e)(3)(ii) of this section shall apply for purposes of allocating 
earnings and profits to such stock, except that earnings and profits 
shall first be allocated to the stock under paragraph (e)(3)(i) of this 
section to the extent of any dividends paid with respect to the stock 
during the taxable year. Additional earnings and profits will be 
allocated to the stock only in an amount equal to the excess (if any) 
of the amount of earnings and profits allocated to the stock under 
paragraph (e)(3)(ii) of this section over the amount of such dividends. 
Notwithstanding the foregoing, if a class of redeemable preferred stock 
with cumulative dividend rights has a mandatory redemption date, and 
all dividend arrearages with respect to such stock compound at least 
annually at a rate that is not lower than 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, based on a comparable compounding assumption, such 
stock shall not be considered for purposes of this section as stock 
with discretionary distribution rights.
* * * * *
    (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 the 
preferred stock is held by Corp J, a domestic corporation, which 
invested $5000x in FC10 in exchange for the preferred stock. Corp H 
is unrelated to Corp J. In 2006, FC10 borrows $3000x from a bank and 
invests $5000x in preferred stock issued by FC11, a foreign 
corporation the common stock of which is owned by Corp J. Corp J's 
adjusted basis in its FC 11 common stock is $5000x. FC11, which has 
no current or accumulated earnings and profits, distributes the 
$5000x to Corp J. Subsequently, in 2007, 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. For 2007, FC10 has $5000x of earnings and profits, all of 
which is subpart F income attributable to a section 304 dividend 
arising from FC10's sale of the FC11 preferred stock to FC12. At all 
relevant times, the value of the common stock of FC10 is $1000x and 
the value of the preferred stock of FC10 is $5000x.
    (ii) Analysis. 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 by depleting the earnings and 
profits of FC12 and allowing FC11 to make a distribution to Corp J 
that it characterizes entirely as a return of basis. FC10 has $5000x 
of earnings and profits for 2007 attributable to a dividend from a 
section 304 transaction which was part of such plan. 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 ($1000x and $5000x,

[[Page 8945]]

respectively). Thus, for taxable year 2007, $833x (\1/6\ x $5000x = 
$833x) of these earnings and profits is allocated to FC10's common 
stock and $4167x (\5/6\ x $5000x = $4167x) 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. * * *
* * * * *

    Approved: February 8, 2006.
Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 06-1532 Filed 2-21-06; 8:45 am]
BILLING CODE 4830-01-P