The Treasury Department and the IRS intend to publish regulations that will provide an exception from the definition of U.S. property under Code Sec. 956 for certain obligations of a United States person with regard to a controlled foreign corporation (CFC). The exception will affect obligations that arise in connection with derivative financial instruments. Taxpayers can rely on the provisions set forth in the guidance until the regulations are issued.
Under Code Sec. 956, U.S. shareholders of a CFC are taxed on their pro rata share of the CFC’s earnings that are invested in U.S. property during the tax year and not distributed or otherwise taxed. The amount of earnings invested in U.S. property is the economic equivalent of a dividend deemed to have been paid, but it is not a qualified dividend eligible to be taxed at capital gains rates because it is not actually distributed ( O. Rodriguez, CA-5, 2013-2 ustc ¶50,420).
What is U.S. Property?
U.S. property generally includes tangible real or personal property located in the United States, stock of domestic corporations, obligations of U.S. persons, and the right to use a patent, copyright, invention, etc., in the United States. In 2012, the Treasury and IRS published Temporary Reg. §1.956-2T(b)(1)(xi), which provides an exception from the definition of U.S. property for certain obligations arising from upfront payments on cleared notional principal contracts (NPCs) with respect to which full initial variation margin was posted. In 2015, the exception was extended to certain obligations of U.S. persons arising from upfront payments made with respect to uncleared NPCs, if certain conditions were met (i.e., the full margin or cash collateral exception).
Definition of U.S. Property Exception Modified
Under the proposed regulations, a new exception from the definition of U.S. property will apply to an obligation that arises in connection with a derivative financial instrument, without regard to the status of the instrument as an NPC. The exception will apply to the extent that the principal amount of the obligation does not exceed the fair market value of cash or readily marketable securities posted or received as margin or collateral for the obligation in the ordinary course of its business by a U.S. or foreign dealer in securities or commodities.
The exception is similar to the exception in Code Sec. 956(c)(2)(J) for obligations for which readily marketable securities are posted as collateral.
Reliance on New Exception
Taxpayers may rely on this rule until regulations are issued, including with respect to obligations arising before May 4, 2018. Alternatively, taxpayers can continue to apply the full margin or cash collateral exception in Temporary Reg. §1.956-2T(b)(1)(xi).