IRC 965 Dividend Repatriation Audit Guidelines
August 27, 2008
The American Jobs Creation Act of 2004 (P.L. No. 108-357) added new section 965 to the Code. Section 965 provides a temporary dividends received deduction (DRD) equal to 85 percent of qualifying cash dividends received by a United States shareholder of a controlled foreign corporation (CFC). There are numerous limitations and special rules applicable to the DRD. The following guidelines have been established to assist examiners with regard to information that should be reviewed during the election year and subsequent tax years and to assist in reviewing section 965 plans.
A. Generally. Section 965 provides an elective, one-year dividend received deduction (DRD) to U.S. corporations equal to 85 percent of certain cash dividends received from their controlled foreign corporations (CFCs).
B. Four Principal Limitations. Section 965 (b) imposes four principal limitations on the DRD.
Section 965(b)(1) caps the amount of dividends eligible for the DRD;
Section 965(b)(2) limits the DRD to certain extraordinary cash dividends in excess of average dividends and other distributions received during a base period;
Section 965(b)(3) reduces the dividends otherwise eligible for the DRD by any increase in the indebtedness of the CFC to any related person; and
Section 965(b)(4) requires that the United States shareholder claiming the DRD invest the amount of the dividend in the United States pursuant to a written domestic reinvestment plan (DRIP) adopted prior to the payment of the dividend.
C. Additional Limits. In addition, section 965 (d) and (e) contain rules limiting the use of tax credits and deductions to offset the nondeductible portion of the dividends eligible for the DRD.
D. Outline of Guidelines. These guidelines summarize the principal rules under section 965, including (1) the definition of cash dividends received by a U.S. shareholder; (2) domestic reinvestment plan (DRIP); (3) the section 965(b)(1) cap on qualifying dividends; (4) the extraordinary dividend requirement; (5) the reduction in benefits for increases in related-party debts; (6) permitted and non-permitted investments in the United States; (7) special rules affecting tax credits and taxable income; (8) the interaction of section 965 with the alternative minimum tax and the AMT credit; and (9) administrative rules. The guidelines conclude by providing an examination checklist.
E. Notices. The principal guidance for this provision was issued in three Notices. Notice 2005-10 (2005-6 I.R.B. 1), released January 13, 2005, primarily addresses the cash dividend and DRIP requirements. Notice 2005-38 (2005-22 I.R.B. 1100), released May 10, 2005, primarily addresses the limitations on the DRD and the impact of corporate restructuring transactions on various section 965 calculations. Notice 2005-64 (2005-36 I.R.B. 471) primarily addresses foreign tax credits, the AMT and minimum tax credits, foreign currency translation issues, disallowed expenses, and the taxable income limitation.
F. Form 8895. Taxpayers elect to claim and report the DRD on Form 8895, One-Time Dividends Received Deduction for Certain Cash Dividends from Controlled Foreign Corporations. The form and its instructions explain the calculations necessary to compute the DRD. Taxpayers must also indicate on the form whether they undertook any restructuring transactions that affected the amount of the DRD. Taxpayers that elected section 965 to apply prior to the issuance of Form 8895 had to make the election on a statement that was attached to their timely-filed tax return (including extensions).
G. Election Period. Taxpayers may elect to claim the section 965 DRD in either their most recent tax year beginning before the date of enactment, October 22, 2004, or in their first tax year that begins on or after October 22. 2004.
II. Qualifying Dividends
A. Dividends. Eligible dividends include not only dividends described in section 316, but also distributions treated as dividends under sections 302 or 304. Dividends resulting from liquidations under section 332 to which section 367(b) apply also qualify to the extent of cash received by the shareholder.
For this purpose, dividends do NOT include deemed dividends under section 78, section 951(a)(1)(A) inclusions, section 956 inclusions, and section 1248 inclusions.
Except to the extent of a cash distribution, a deemed liquidation effected by a check the box election of a foreign subsidiary does not constitute a cash dividend. See section 965(c)(3), section 2, Notice 2005-10, and section 3 of Notice 2005-64.
Unlike the determinations of base period amounts and the APB limitation, the amount of cash dividends paid in the election year can be affected by audit or other adjustments made after the election year return is filed.
Dividends from foreign sales corporations are included in dividends described in section 965(a), but taxpayers cannot claim DRDs under both section 965 and 245 with respect to such distributions. See section 965(c)(4).
B. Previously-Taxed Income. Distributions of previously-taxed income from a CFC are not generally eligible for the DRD because they are not dividends. See section 959(c).
The normal ordering rules in section 959 generally apply. Therefore, except as described in section II(B)(2) below, a CFC must distribute all of its PTI before any distribution counts as an eligible dividend.
Section 965(a)(2), however, treats any cash distribution of PTI from a CFC to a U.S. shareholder as a cash dividend, but only to the extent the U.S. shareholder has a Subpart F inclusion in the election year attributable to a cash dividend paid by a lower-tier CFC in the same chain of ownership under section 958(a). For example, assume U.S. shareholder wholly owns CFC which, in turn, wholly owns CFC Sub and CFC Sub pays a dividend of 100 that gives rise to a Subpart F inclusion of 100 to U.S. shareholder in the election year. If CFC distributes 100 in the election year, the distribution is previously taxed income under section 959, but is treated as a cash dividend for purposes of section 965(a).
C. Cash Requirement. Only "cash" dividends are eligible for the DRD. See section 965(a).
Cash includes distributions in U.S. or foreign currency;
Payments of "cash equivalents" as defined in section 1.897-7T are NOT eligible for the DRD. Examples of "cash equivalents" include bank accounts, certificates of deposits, money market accounts, commercial paper, bonds, precious metals or commodities, and publicly traded instruments. Note: The step transaction doctrine will not be applied during examination if a CFC converts cash equivalents to cash to pay the dividend and the shareholder converts the cash back to the same or similar cash equivalents prior to making the requisite investment in the U.S. See section 3.01, Notice 2005-10.
Payments can be made by wire transfer, check, or other similar means of remitting cash.
Note that the "cash" requirement applies only for purposes of determining the qualifying dividends and does not apply in calculating the base period amount. See section V below. Therefore, the DRD is based on the excess of cash dividends paid in the election year over the base period amount, which includes all dividends, cash or otherwise, and certain other amounts. Section 965(b)(2).
D. Receipt. The dividends must be received by a U.S. shareholder as defined in section 958(b).
Only corporations that receive qualifying dividends are eligible for the DRD, see section 965(a), but distributions may be received by a partnership or disregarded entity owned by a corporate U.S. shareholder of the CFC to the extent that the cash received by the intermediary entity is distributed to the corporation within the election year. Section 3.02, Notice 2005-10. For this purpose, a loan from an intermediary entity to its owner will not be considered a qualifying distribution as there is obligation to repay the loan, but remittances of cash from a DE that do not create any legal obligation for repayment are considered a remittance (e.g., satisfaction of pre¬existing debts owed by a DE to corporate owner). Section 9.06, Notice 2005-38. But see section 10.09, Notice 2005-64 (requiring actual distributions from intermediary partnerships).
Dividends received by pass-through entities need not be remitted to their corporate owners, however, for purposes of determining the base period amount under section 965(b)(2)(B).
The dividends must be paid by a CFC as defined in section 957.
E. Election. Section 965 is elective, but if properly elected must be applied to all qualifying distributions to the electing shareholder from its controlled foreign corporations. See section II(F) below (all members of a consolidated group are treated as a single U.S. shareholder for purposes of section 965). If an electing taxpayer does not want section 965 to apply to certain of its distributions during the election year (e.g., because it does not want to forfeit any credits or deductions attributable to such distributions), it must adopt a dividend reinvestment plan that does not include such distributions. See section III below.
F. Consolidated Groups. An members of a consolidated group are considered a single shareholder for purposes of determining eligibility and limits on the DRD. Section 965(c)(5).
III. The Domestic Reinvestment Plan (DRIP)
A. Generally. Cash dividends are eligible for the DRD only if distributed pursuant to a properly adopted DRIP. Section 965(b)(4).
B. Approval. The DRIP must be approved by the U.S. shareholder's CEO, President or other similar officer. The Plan must also be subsequently ratified by the Board of Directors or similar body. In cases where the U.S. shareholder is included on a consolidated return, the relevant officers and board are those of the parent corporation of the group.
C. Timing. The DRIP must be approved by the CEO (or other sanctioned officer) before the payment of any qualifying dividend. However, if a DRIP was modified to conform to subsequently issued IRS guidance, previously remitted dividends may nevertheless qualify. Section 9.02, Notice 2005-10; Section 11.01, Notice 2005-38; Section 11.01, Notice 2005-64.
The DRIP must be in writing.
The DRIP must provide for one or more specific anticipated qualifying investments in the U.S. and contain sufficient detail to allow the Service to determine if the dividends were reinvested as intended when the DRIP was adopted.
A DRIP that simply recites the broad types of investments that qualify under the section 965(b)(4)(B) is inadequate. Section 4.03, Notice 2005-10. Nor may a DRIP simply recite that funds will be reinvested in the U.S. using the broad language in the statute (i.e., "for worker hiring and training, infrastructure, research and development, capital improvements, or the financial stabilization of the corporation for the purposes of job retention or creation"); however, Exam should be flexible on the wording of the investments.
The DRIP must include the amounts to be expended on each principal type of investment and a reasonable timeframe for making the investments.
The DRIP may also specify qualifying alternative investments should the shareholder's plans change. Given that amendment after dividends are paid is not generally permitted, it is expected that most plans will include alternatives.
E. Multiple DRIPs. Different DRIPs may be adopted for different dividends. In such cases, the DRIP must specify the dividends to which the plan relates. For example, a DRIP may be expressly limited to specific distributions, distributions from particular CFCs, or specific amounts distributed from one or more CFCs.
F. Amendment. DRIPs generally may not be amended once a qualifying dividend has been paid except to conform to subsequently issued IRS guidance. See section 111(C) above, indicating that in some cases a DRIP may be modified to conform to subsequently issued IRS guidance.
IV. Cap on Eligible Dividends (section 965(b)(1))
A. The Cap. The maximum amount of cash dividends eligible for the 85% DRD is the greater of:
the amount shown on the applicable financial statement as permanently reinvested outside the U.S., or
if the applicable financial statement does not show permanently reinvested earnings but does show the tax attributable to such earnings, then the limit is the amount of such taxes divided by 0.35.
a) Note that if the tax liability attributable to permanently reinvested amounts is net of foreign taxes, taxpayers may not add back any foreign taxes prior to dividing the liability by 0.35.
b) The amounts described in section IV(A)(2) and (3) are those amounts determined under paragraph 12 of APB 23 and disclosed under Financial Accounting Standards Board Statement 109, regardless of the precise language used to describe the amount. These amounts are generally referred to as the "APB 23 limitation."
B. Applicable Financial Statement. The applicable financial statement for purposes of determining the APB 23 limitation is the most recent financial statement certified on or before June 30, 2003 as being prepared in accordance with GAAP. If the taxpayer is required to file its financial statements with the SEC, the audited financial statement must have been filed on or before June 30, 2003, to be used for this purpose.
The financial statement includes notes and other documents that form an integral part of the statement, but does not generally include the work papers or other supporting materials. Section 4.01 of Notice 2005-38.
A restatement of a financial statement after June 30. 2003, is not taken into account in determining the APB 23 limitation. See section 10.04 of Notice 2005-64.
Section 965(c)(5)(C) provides that if a financial statement is an applicable financial statement for more than one U.S. shareholder, the APB 23 limitation is divided among such shareholders under regulations prescribed by the Secretary.
a) In such a case, the portion of the APB 23 limitation allocated to the U.S. shareholder is the amount from the separate company financial statements (or supporting work papers) of such U.S. shareholder that were prepared in connection with determining the amount shown on the applicable financial statement that included such U.S. shareholder.
b) Section 965(c)(5)(C) contemplates not only the situation where the financial statement reflects the operations of affiliated corporations that are not consolidated for tax purposes (for example, a U.S. corporation and a domestic subsidiary that elect to apply section 936), but also the situation where the financial statement reflects the operations of corporations that were formerly affiliated and/or consolidated but are not in such relationship during a section 965 election year.
c) The portion of the APB 23 limitation allocated to the U.S.
shareholder follows the U.S. shareholder and not the CFC.
C. Allocation of Cap. A consolidated group is generally considered a single taxpayer for purposes of the cap on the dividends eligible for the DRD. See section 965(c)(5).
If a taxpayer does not have an amount reflected on an applicable financial statement, section 965(b)(1) limits the amount of dividends eligible for the section 965 (a) DRD to $500 million.
Both the APB 23 limitation and the $500 million must be allocated among the appropriate U.S. shareholder. See section B above for the basic rule for the APB 23 limitation allocation.
In cases where the $500 million limit applies, that limit must be divided among all corporations that are treated as a single employer under section 52(a). This is generally a controlled group of corporations under section 1563(a) using a 50% ownership test.
Examiners should be alert to non-consolidated entities in the group such as 936 corporations, insurance companies, stapled companies and any other deconsolidated companies. Similarly, the APB 23 limitation may also be determined with reference to multiple taxpayers (i.e., where audited financials include members outside the consolidated group).
Section 4 of Notice 2005-38 provides guidance on allocating the cap on dividends eligible for the DRD.
a) Where multiple taxpayers are included on an applicable financial statement or included in a section 52(a) group, they do NOT have discretion to determine how the eligible amounts are shared among members of the group.
b) The $500 million limit is divided among the section 52(a) group members treated as a single employer on the last day of the latest election year of any member of such group. The $500 million is allocated among such members based on their respective shares of the total non-previously taxed earnings and profits of the CFCs owned by such members based on the most recently filed forms 5471.
c) In dividing the $500 million limitation, each qualified member of a section 52(a) group is allocated a portion of the section 52(a) group's single $500 million limitation if it is a qualified member on the last day of the election year of the qualified member with the last election year to end (apportionment date). A "qualified member" is either: (1) a domestic corporation that files a separate tax return and is a member of a section 52(a) group; or (2) a consolidated group that is part of a section 52(a) group. Thus, if a consolidated group is not a part of a section 52(a) group, it has its own $500 limitation, and, if a consolidated group is part of a section 52(a) group, the portion of the $500 million allocated to the consolidated group is not further allocated between and among the members of the consolidated group. See sections 4.05 and 6.02 of Notice 2005-38.
d) The APB 23 limitation is divided among the corporations to which it applies based on their separate company financial statements (or work papers) prepared in connection with the applicable financial statement.
D. Effect of Restructuring on Limitation. The APB 23 Limitation with respect to a particular U.S. shareholder is considered fixed as of the filing of the applicable financial statement and becomes a tax attribute of the U.S. shareholder. Once fixed, the attribute transfers with the U.S. shareholder (or its assets in cases of certain reorganizations) under the principles of section 381. A disposition of a CFC after the limitation is fixed does not affect the U.S. shareholder's APB limitation.
Generally, when a U.S. shareholder (or its assets) is sold after the APB limitation is fixed, the APB limitation of the selling group is decreased and the limitation of the acquiring group is increased by amount of limitation attributable to the target.
Special rule for sales in election year. Where the U.S. shareholder is sold during the section 965 election year of the selling group, however, the APB limitation of the selling group is not decreased, but the limitation of the acquiring group is increased by the limit attributable to the target. See section 6.01(c) of Notice 2005-38.
For additional rules on the impact of restructuring during the base period and election year, see section 6 of Notice 2005-38.
There are special rules for certain base period spin-off transactions. See section 6.01(c) of Notice 2005-38.
V. Extraordinary Dividend Requirement (section 965(b)(2))
A. Dividends are eligible for the DRD only to the extent that they exceed a base period amount that is the average of dividends and certain other amounts distributed during a five-year period that ends on or before June 30, 2003. See Section 2.02 and Section 3 of Notice 2005-38.
B. Amounts included. The amounts included in the base period are all dividends, whether paid in cash or property, deemed dividends resulting from section 956 inclusions, dividends from foreign sales corporations, and distributions of PTI (to the extent not attributable to a prior section 956 inclusion).
The U.S. shareholder's status relative to a distributing company during the election year is not relevant for purposes of determining the base period amount. If the shareholder was a U.S. shareholder of the distributing CFC in the year of the distribution, the amount is included in the base period. Section 3.01(a) of Notice 2005-38.
Amounts deemed to be received through a disregarded entity or partnership and reported on the U.S. shareholder's return as one of the types of income listed in 965(b)(2) are included in the base period, regardless of whether such income was actually distributed to the shareholder. Similarly, distributions of such amounts by a CFC to a U.S. partnership owned by the corporate U.S. shareholder are also generally included in the base period amount. See section 10.02 of Notice 2005-64.
Distributions of PTI included in the base period are translated into U.S. dollars using the spot rate on the date of distribution. Section 3.02 of Notice 2005-38.
C. In determining base period dividends, the amounts reported on the most recent return filed prior to June 30, 2003, for each such year will be used regardless of later amendment or audit activity. Thus, increases in subpart F inclusions during an examination of base period years will not change the amount of the base period dividends (unless also reflected on amended returns filed prior to June 30. 2003). but will result in an increase in the amount of PTI that must be distributed in the election year before a distribution is generally treated as a dividend. That may affect how much a CFC must distribute to exceed the base period amount unless the shareholder is relying on section 965(a)(2).
D. Base period years. Base period amounts are determined for each year in a five-year period which ends on or before June 30, 2003.
Short taxable years count as a full year and distributions received during such period are not annualized. See section 3.01(c) of Notice 2005-38.
In cases where a U.S. shareholder undertakes a spin-off under section 355 (or so much of section 356 that relates to section 355), the distributed U.S. shareholder is treated as having been in existence for as long as the distributing corporation. See section V(F) below for rules describing division of base period amounts in such cases.
E. Mechanics of Base Period Calculation
Total all included distributions received by the U.S. shareholder in each of the base period years.
a) A consolidated group determines its base period inclusions by first aggregating the base period inclusions of each of the group members.
b) Taxable years of fewer than 12 months are taken into account as taxable years. Base period inclusions in a tax year of fewer than 12 months are not annualized.
Exclude the two years in which the greatest and least amounts were distributed.
Average amounts distributed in each of the remaining years.
If there are less than five years in the base period, all available years ending on or before June 30. 2003 are averaged to determine the base period amount.
There are special rules for certain spin-off transactions. See section 6.01(c) of Notice 2005-38.
F. Effect of Restructuring
Base period inclusion amounts are considered tax attributes of the receiving U.S. shareholder once they are included in income and are treated in the same way as items described in section 381(c). Thus, base period amounts may be shifted between taxpayers (or consolidated groups of taxpayers) upon the sale of a U.S. shareholder's stock or assets in the case of section 381 transaction.
a) Dispositions of CFC stock or assets, however, do not affect a U.S. shareholder's base period amount. See section 6.01 of Notice 2005-38.
b) Moreover, unless a section 381 transaction is involved, dispositions of assets by a U.S. shareholder do not affect the base period amount.
Special rules apply where a transfer occurs within the 965 election year. In such cases, a selling consolidated group does not reduce its base period amount by the amount associated with a departing U.S. shareholder member. Note, however, that the base period amounts attributable to that member are included in the base period amounts of the acquirer. Section 6.01(h)(2) of Notice 2005-38.
In spin-offs occurring during the base period, base period inclusions are divided based on each entity's share of CFCs immediately after the spin-off. See section 965(c)(2)(C)(ii). For other spin-off transactions, the base period inclusions are considered tax attributes of the U.S. shareholder and are treated in the same way as described for other section 381 attributes. See section 6.01(c) of Notice 2005-38.
VI. Reduction of Eligible Dividends by Increase in Related-Party Debt (section 965(b)(3))
A. The amount of otherwise qualifying cash dividends is reduced to the extent that the U.S. shareholder (and related parties) increase the amount loaned to a distributing CFC.
B. Congress was concerned that U.S. shareholders could fund their own dividends by loaning money to CFCs and this would undermine Congressional intent to encourage the flow of cash and investment into the U.S.
C. The increase in debt is generally computed by comparing the total amount owed by a CFC to related parties on two measurement dates –October 3, 2004 (the beginning measurement date) and the last day of the election year (the last measurement date). Any excess of the amount of debt on the last measurement date over the amount of debt on the beginning measurement date is considered an increase in related party indebtedness under section 965(b)(3).
Beginning date. Since October 3, 2004 is a Sunday, Notice 2005-38 provides for an alternate computation date based on the end of the month or quarter immediately prior to October 3, 2004. See section 7.01(vi) of Notice 2005-38.
Adjustments. Adjustments to initial measurement of related party indebtedness must be made for certain transactions. See section 7.05 of Notice 2005-38.
Allocation of Related Party Indebtedness. An increase in a CFC's related party indebtedness may not reduce the total amount of dividends otherwise eligible for the section 965(a) DRD on anything but a dollar-for-dollar basis. Consequently, if more than one U.S. shareholder is a related person with respect to a CFC, then the effect of the increase in the related party indebtedness of the CFC pursuant to section 965(b)(3) is allocated among and between such U.S. shareholders. See section 7.06 of Notice 2005-38.
D. Indebtedness. Indebtedness is not specially defined and thus has its general meaning for tax purposes except as noted below.
The amount of debts owed by a CFC to a lender is not reduced by offsetting debts owed by the lender to the CFC. Thus, debts are measured on a gross rather than a net basis.
For this purpose, debt does not include the following ordinary course obligations of CFCs:
a) obligations in the ordinary course of the CFC's business from sales, leases, licenses, or the rendition of services provided to or for a CFC by a related person, provided such obligations are actually paid within 183 days. See Section 7.02 of Notice 2005-38 and Section 10.08 of Notice 2005-64.
b) obligations in the ordinary course of the CFC's business as a bank or dealer in securities that would not be treated as U.S. property under section 956(c)(2)(A)(i). (J). (K), or (Ii) if they were obligations of a U.S. person. See section 10.07 of Notice 2005-64. Note that banks generally take deposits from unrelated persons. See sections 581 et seq.
For this purpose, debt includes accounts payable established under Rev. Proc. 99-32 in connection with section 482 adjustments. See section 10.06 of Notice 2005-64.
E. All CFCs owned by the U.S. shareholder are treated as a single CFC for this purpose. Therefore, any debts between such CFCs are disregarded in computing related party indebtedness. Note, however, that loans from related foreign entities that are not CFCs with respect to the U.S. shareholder are included in related party indebtedness even though loans from such entities do not originate in the U.S.
F. Related person includes anyone related to the CFC within the meaning of section 954(d)(3).
G. Debts are included as of a measurement date if, at that time, the CFC owes a debt to a related person, regardless of whether the two entities are related as of the other measurement date.
H. Relation to Other Limits Under Section 965(b). The reduction in dividends eligible for the DRD under section 965(b)(3) is made only after all other limitations under section 965 (b) are applied.
I. Translation of Non-Dollar Debts. Any debts denominated in a non-dollar currency are translated into U.S. dollars at the spot rate on the initial measurement date. See section 7.07 of Notice 2005-38. This rule is necessary to eliminate the effect of changes in foreign currency relative to the dollar during the measurement period.
J. Avoidance. The related-party debt limitation was intended by Congress to deny the DRD in cases where a U.S. shareholder directly or indirectly provided the funds from which the CFC dividend was paid. Such a circular flow of cash is contrary to the stated purpose of the provision, which is to encourage U.S. shareholders to make new investments in the United States. Accordingly, section 965(b)(3) also provides that the Service may issue regulations "necessary or appropriate to prevent the avoidance of the purposes of this paragraph, including regulations which provide that cash dividends shall not be taken into account under subsection (a) to the extent such dividends are attributable to the direct or indirect transfer (including through the use of intervening entities or capital contributions) of cash or other property from a related person (as so defined) to a controlled foreign corporation." Although no such regulations have been issued to date, section 965 benefits should not be available in cases where, under general tax principles, a series of circular transfers of property would be disregarded as without substance.
Loan v. Guarantee. Issues may arise with regard to a parent–s guarantee of a third party note as constituting related party indebtedness. Generally, a related party guarantee of CFC indebtedness is not considered to be an indirect financing for these purposes. Section 7.04(b) of Notice 2005-38 discusses the case law that should be reviewed in this area.
The repayment of debts owed to a CFC that, in turn, pays a dividend will not generally constitute an impermissible circular flow of cash for this purpose.
Transfers of cash from a U.S. shareholder to a CFC will not be regarded as circular where the cash is transferred in return for goods or services of commensurate value.
Other capital contributions also may not be treated as circular if not made with the purpose of funding dividends eligible for the DRD.
VII. Reinvestment Requirement (section 965(b)(4)).
A. The full amount of the dividend. unreduced by allocable expenses or taxes, must be invested in the U.S. For example: The U.S. shareholder receives a $100,000 dividend that qualifies for the section 965 DRD ($85,000) on which a foreign withholding tax of $10,000 was imposed. Even though the U.S. shareholder receives $90,000, the entire $100,000 must be reinvested in the U.S. in order to claim the DRD.
B. No incremental investment requirement. Any amount expended on a qualifying investment in the U.S. counts toward satisfying the investment requirement. There are no requirements that such investments exceed investments made in prior years or those previously planned for the election or subsequent years. Section 4.01, Notice 2005-10. For example, if a taxpayer normally spends $100,000 on advertising that would qualify as a permitted investment; the qualifying expenditure does not have to exceed that amount pursuant to a DRIP.
C. Timing of Investments
Any otherwise qualifying expenditures made in the election year count towards the reinvestment requirement, even if made prior to adoption of the DRIP. Section 4.06, Notice 2005-10. When the expenditure is a contribution to a qualified plan under section 401(a), the controlling year is the year when the expenditure is made, not the plan year to which the contribution relates.
Also note that the statute does not provide a deadline for making qualifying investments. This has the potential to create statute of limitations problems since the DRD is taken in the election year, but investments can be made several years thereafter. See section XII(E) and (F) below for administrative considerations.
D. No Tracing Requirement. Dividends do not have to be segregated or traced to expenditures. The permitted investments merely have to be equal to the amount of the qualifying dividend. Thus, it does not matter if a taxpayer uses dividends to make non-permitted investments, provided it ultimately invests the amount of the qualifying dividend.
E. Effect of Failure to Complete Reinvestment. Failure to invest all of a qualifying dividend does not result in loss of the entire DRD, but rather only a pro rata portion of the amount not properly invested. For example, if taxpayer claims a $127,500 DRD with respect to a $150,000 dividend, but reinvests only $100,000, the taxpayer is still entitled to a DRD of $85.000. Section 4.07, Notice 2005-10.
F. Consolidated Groups. Otherwise permitted expenditures help to satisfy the reinvestment requirement if made by any entity that is a member of the consolidated group on or after the beginning of the election year, regardless of whether they were a member during the base period or election year. See section 8.02 of Notice 2005-38.
G. Asset Acquisitions. Expenditures by an acquiring corporation will be considered qualified reinvestments with respect to a DRIP of a corporation whose assets were acquired in a transaction described in section 381(a).
H. Attribution of Investments to DRIPs. In cases where a taxpayer has more than one DRIP, it may expressly designate a given expenditure as satisfying a particular DRIP. Where no such identification is made, the expenditure is generally attributed to the earliest adopted plan to which it may relate. See section 8.04 of Notice 2005-64.
I. Collateral Effects. Receipt of qualified dividends may cause an entity to be treated as a personal holding company under section 542. Note that in computing undistributed personal holding company income, however, the section 965 DRD should be allowed, but current Schedule PH of Form 1120 does not expressly provide for that deduction.
VIII. Permitted Investments
A. Generally. Section 965(b)(4) requires that any dividends with respect to which the DRD is claimed be invested in the U.S.
B. Investments in the U.S. Section 965 does not define investment in the U.S., but provides a non-exclusive list of permitted investments: A worker hiring and training, infrastructure, capital investments, R&D, and financial stabilization for the purpose of job retention or creation.
C. Unrelated Parties. Purchases must be made from unrelated parties. For example. a purchase of equipment from a sister corporation does not qualify as a reinvestment. However, expenditures by other members of a consolidated group are permitted. Therefore, wages or other qualifying expenditures incurred by another consolidated group member will count as a reinvestment in the U.S. even if another member actually received the dividend.
D. Cash Requirement. Permitted investments must be made in cash. Where an investment is made with borrowed proceeds, the cost of the investment will be considered invested in the U.S. only when the debt is repaid. Thus, stock may not be used to make a permitted investment.
E. A single expenditure cannot be used to satisfy more than one DRIP.
F. Section 5 of Notice 2005-10 specifies that the following types of investments satisfy the reinvestment requirement:
Funding of worker hiring, training and other compensation - this generally includes compensation paid to both new and existing workers and the funding of a qualified plan under section 401(a). However, such expenses are not permitted to the extent they relate to payments for executive compensation (see section VII(b) below) or services rendered outside the U.S.;
Infrastructure and capital improvements in the U.S. - this includes investments in plant, property, and equipment, communications and distribution systems, computer hardware and software, and payments for services rendered in connection with implementing such investments.
Research and development expenditures - this includes expenditures described in section 1.174-2 to the extent such activities are conducted in the U.S. and the expense is borne by the taxpayer (i.e., costs paid by the taxpayer are not eligible if reimbursed by a third party).
Interests in business entities - the purchase of equity interests in a business entity qualifies as a reinvestment to the extent of the purchaser's pro rata share of the target's assets that would have qualified as a permitted investment if purchased directly. This rule only applies, however, where the acquiring shareholder holds at least 10 percent of the target, by value, after the acquisition. Note, however, that purchases must be from an unrelated entity. See section VIII(C) above. See also section 5.06 of Notice 2005-10 for allocation rules and for a de minimis test that would treat an entire acquisition as either permitted or non-permitted.
Advertising and marketing expenditures are reinvestments provided that the marketing activities occur in the U.S.
Intangible property - expenditures to acquire or license intangible assets are permitted to the extent such assets are used in the U.S.
Financial stabilization for the purpose of job creation or retention - this includes repayment of debt or satisfaction of an obligation to fund a qualified plan provided that, at the time the DRIP is approved, it is in the taxpayer's reasonable business judgment that the resulting stabilization will be a positive factor in its ability to retain and create jobs in the U.S.
a) Taxpayers are not entitled to rely on debt repayment as a permitted investment where, at the time of repayment, taxpayer intended to incur additional debt on similar terms to repaid debt. However, taxpayers are not required to demonstrate a reduction in the level of their global debts. Thus, CFCs may incur debts to unrelated parties to fund dividends that are used to satisfy the U.S. shareholder's debts. See section 5.05(a) of Notice 2005-10.
b) Payments to a qualified plan are permitted on financial stabilization grounds where they do not give rise to excise tax under section 4972, even if not currently deductible. See section 10.11 of Notice 2005-64. However, payments to a qualified plan may also be a permitted investment as funding worker compensation. See section VII(F)(1) above.
c) Other expenditures may also contribute to financial stabilization for one of the requisite purposes if, in the taxpayer's business judgment, the resulting stabilization will be a positive factor in its ability to retain and create jobs in the U.S
Because the list of investments in the U.S. in section 965(b)(4) is non-exclusive, other types of expenditures may also qualify as investments provided they are not described in section IX below.
IX. Non-permitted Investments
A. Section 6 of Notice 2005-10 lists several types of expenditures that are not qualified reinvestments in the United States.
B. Executive Compensation - section 965(b)(4)(B) specifies that executive compensation is not a qualified reinvestment.
The term "executive" is defined in section 16(a) of the Securities and Exchange Act of 1934. This includes "(i) an issuer's president, (ii) any vice president in charge of a principal business unit, division or function (such as sales, administration, or finance), (iii) the principal accounting officer (or, if none, controller) and principal financial
officer, and (iv) any other person (including an officer of a parent or subsidiary) who performs for the issuer a policy-making function that is significant."
Companies not subject to section 16(a) may apply that section as if they were, or may treat the ten highest paid employees in the most recently ended calendar year as executives for this purpose. Companies that are subject to section 16(a) are not allowed to use the ten highest paid employees rule.
C. Intercompany distributions, obligations, and other transactions are not permitted reinvestments. Similarly, stock redemptions and dividends to shareholders are not permitted expenditures even if a taxpayer purports to show that stock redemptions are financially stabilizing.
D. Acquisition of portfolio interests in business entities (less than a 10% interest) is not a permitted investment unless purchaser holds the requisite 10% interest in target after the purchase and target is not considered a related party.
E. Acquisition of debt instruments.
F. Tax payments – this includes social security taxes imposed on an employer with respect to wages paid. Note, however, that social security taxes withheld from an employee's compensation are taxes imposed on the employee and, therefore, are treated as part of a permitted expenditure on compensation by the employer.
G. The treatment of investments made by related, but non-consolidated entities such as a partnership owned by the U.S. shareholder is not addressed in section 965 or the Notices.
X. Calculation of Taxable Income and Foreign Tax Credit
A. Notice 2005-64 contains detailed guidance on (1) taxpayer's ability to identify dividends that qualify for the DRD; (2) additional limits, under section 965(d) & (e), on deductions, taxable income, and the use of credits to offset the U.S. tax on nondeductible section 965 dividends, (3) the interaction of section 965 and foreign tax credits, and (4) the effect of section 965 on the alternative minimum tax (AMT).
Identification of Dividends. If a U.S. shareholder receives more than one cash dividend in a year, it may elect which of its dividends carry the DRD and which satisfy the base period amount, if any, or are otherwise ineligible for the DRD. Identification is primarily relevant because U.S. shareholders are not entitled to credit or deduct foreign taxes attributable to the deductible portion of its dividends. Thus, taxpayers are generally expected to designate dividends that bear little or no foreign taxes as being deductible.
B. Where an election is made, any given dividend must either be eligible for the DRD or ineligible in full. However, where the amount qualifying for the DRD is less than the total amount of identified cash dividends, the taxpayer may identify which dividend is only partly eligible for the DRD. A pro rata portion of that dividend will be treated as eligible for the DRD. See section 3 of Notice 2005-64.
C. The election is made by identifying each cash dividend on Form 8895.
D. If the taxpayer does not identify dividends, then a portion of each cash dividend shall be treated as the qualified dividend equal to the cash dividends qualifying for the DRD over the total cash dividends received.
E. Special Rules Affecting Taxable Income
Generally. In addition to the DRD provided under section 965(a), section 965 contains several rules that can affect the determination of taxable income. Section 965(d)(2) disallows a deduction for certain expenses related to generating the DRD. Section 965(e)(2) generally prevents expenses or losses from reducing taxable income below the amount of nondeductible dividends. Section 965(e)(1) also precludes
any credits other than the AMT credit (section 53) and a limited foreign tax credit (section 27) from offsetting the tax liability with respect to nondeductible dividends. In addition, section 965(d)(4) provides a special rule for determining the section 78 gross-up. Each of these rules is described more fully below.
Non-Deductible Expenses (section 965(d)(2))
a) Generally. Because 85 percent of the qualifying dividend is not taxed, section 965(d)(2) provides that 85% of otherwise deductible expenses that are directly related to generating such dividends are not deductible. This disallowance was defined narrowly and is limited to expenses directly related to the payment of the dividend.
(1) Nondeductible expenses are legal, accounting, consulting and other similar expenses (whether paid to employees or third parties) incurred in evaluating, adopting, and implementing the payment of dividends described in section 965, wire transfer and similar transaction costs incurred in the payment of the dividends, and stewardship expenses definitely related to the dividends.
(2) Other expenses and losses remain deductible (subject to the limitation under section 965(e)(2)). For example, a hedging loss recognized when a corporation hedged its currency risk on the dividends eligible for the DRD is not limited by section 965(d)(2).
b) Taxes. Section 965(d)(1) prohibits electing taxpayers from crediting or deducting the foreign taxes attributable to the deductible portion of a dividend. Thus, 85% of the foreign taxes allocated and apportioned to eligible dividends – i.e., taxes
imposed directly on such distributions and taxes deemed paid under section 902 with respect to such distributions. See section X(H) below regarding the foreign tax credit.
F. Taxable Income Limitation. Congress did not want those taxpayers that elect section 965 to also claim a loss in the election year. Therefore, section 965(e)(2) prevents taxpayers from reducing their taxable income below the amount of their non-deductible dividend income (i.e., the 15% of extraordinary dividends that remain after taking the DRD). Therefore, any expense or loss that would otherwise reduce taxable income below that amount cannot be taken in the election year and is effectively suspended in a net operating loss that is subject to the normally-applicable NOL carryover rules.
G. Limits on Use of Credits
Section 965(e)(1) generally precludes the use of tax credits other than the AMT credit (section 53) and a limited foreign tax credit from offsetting the taxes imposed on nondeductible dividends.
For a detailed discussion of the interaction of section 965 and the AMT credit, see section XI(B) below.
H. Foreign Tax Credits
Generally. Taxpayers are permitted to claim foreign tax credits subject to all generally applicable limitations for foreign taxes imposed on the nondeductible portion of qualifying dividends. With one major exception discussed below, section 965 does not generally alter how the foreign tax credit limitations are determined. Thus, dividends from CFCs continue to be allocated to section 904(d) baskets on a look-through basis and the rules for allocating expenses, losses, and loss recapture among the baskets continue to apply.
The qualifying dividends must be assigned to separate baskets and the DRD must also be allocated and apportioned. Thus, section 965(a) dividends are not considered a separate, new basket, but are allocated and apportioned under generally applicable principles.
a) However, expenses, losses, and loss recapture are generally applied first against any income in the basket other than the nondeductible dividends. See sections 6-8 of Notice 2005-64. This was done to adhere to Congressional intent to preserve nondeductible dividends in the tax base. Taxpayers may seek to apply expenses ratably against 965 dividends and other income to limit the amount of nondeductible dividends subject to 965(e)(1) limit on allowable foreign tax credit.
The full amount of the section 965 dividend and base period dividends along with associated foreign taxes will reduce the distributing CFC's E&P pools and foreign tax pools without regard to the 85% DRD or disallowance.
Interest expense and other expenses are allocated and apportioned to the qualifying dividends in the election year. That is, section 965 dividends and the CFC stock to which they relate are NOT treated as exempt income or assets as described in section 1.861-8T. Taxpayers may elect to change from gross income method to sales method of R&E expense apportionment for the election year to minimize amount of expense attracted to general limitation income. Such a change is generally binding for 5 years.
OFL and SLL rules still apply. These rules generally provide that the income otherwise in a basket is moved to recapture previously recognized losses, but the taxes allocated and apportioned to such income is not moved. This may substantially limit a U.S. shareholder's ability to claim foreign tax credits in the election year. See section 8 of Notice 2005-64.
Additional Limitation on FTC. Section 965(e)(1) provides that, although nondeductible dividend income is included in section 904(d) baskets, any foreign taxes imposed on other income cannot be credited against the U.S. taxes imposed on nondeductible dividend income. This additional limitation is applied after the basket-by-basket limitation in section 904(d) and further limits the credits available with respect to any basket including nondeductible dividends to the sum of the taxes imposed with respect to such dividends and a modified FTC limitation computed by excluding the nondeductible dividends from the limitation calculations. If nondeductible dividends are reduced by expense apportionment or OFL/SLL recapture, foreign taxes attributable to the dividends are correspondingly reduced. See section 9.02 of Notice 2005-64 for guidance in determining how the special limitation applies.
I. Section 78 Gross-Up. There is no section 78 gross-up with respect to deemed paid foreign taxes imposed on the deductible portion of a dividend. Because taxpayers are not permitted to claim credits with respect to such taxes (see section X(E)(2)(b) above), it follows that such amounts should not be included in taxable income. See section 965(d)(4).
XI. Interaction of Section 965, the AMT, and AMT Credit
A. AMT Computation in Election Year. Section 965(e)(1) provides a special rule for determining the AMT for taxpayers electing section 965. The AMT is computed under section 55 by excluding the nondeductible dividends from the regular tax under section 55(a)(2) and the tentative minimum tax under section 55(a)(1). Because nondeductible dividends are excluded from alternative minimum taxable income, they are also excluded for purposes of computing the 90% limit on AMT net operating losses under section 56(d)(1)(A)(ii). Similarly, the AMT foreign tax credit must be
computed as if the taxes imposed on the nondeductible dividends were not paid or accrued. See section 9.05 of Notice 2005-64 and Form 8895 for further guidance.
a) These rules are generally intended to result in the imposition of the same amount of AMT as if the nondeductible dividends had not been paid. Thus, U.S. shareholders must generally pay the minimum tax rate on income other than the nondeductible dividends and the regular tax rate on the nondeductible dividends.
b) Note that the exclusion of nondeductible dividends for section 53 purposes does not extend to the determination of AMT credits under section 55. See section XI(B) below.
2. Note that the instructions for line 25 on Form 8895 do not provide correct results for some AMT taxpayers that would have had a taxable loss but for section 965. Specifically, the instructions use the minimum taxable income reported on Form 8895 (line 16) as the starting point for the AMT computations, but the tentative minimum taxable income might, in fact, be less than that (or negative) because it is not subject to section 965(e)(2) for purposes of computing the minimum tax under section 55.
B. AMT Credits. The AMT credit under section 53 may offset the tax on nondeductible dividends, but remains subject to the section 53(c) limit on the use of that credit. The section 53(c) limit is computed by including the nondeductible dividends in the determination of both the regular tax liability and the tentative minimum tax. See section 9.04 of Notice 2005¬64. Similarly, the foreign tax credits taken into account in determining the regular tax liability and tentative minimum tax under section 53(c) include any foreign tax credits related to the non-deductible dividends, but are subject to the limitations under section 965(e)(1) on cross-crediting. As a
result of these rules, taxpayers are not able to use section 53 credits to offset entirely their regular taxable income in the election year.
Reporting and Administrative Requirements
A. The election to apply section 965 is made on Form 8895 which must be attached to the election year return. But see section 9.03 of Notice 2005-10 for returns filed prior to the issuance of Form 8895.
B. Timing. The election can be made either for the most recent taxable year ending before October 22, 2004, or for the first taxable year beginning on or after that date. See section 5 of Notice 2005-38.
For taxpayers that are members of a consolidated group, the common parent may elect on behalf of all the members to apply section 965 to an eligible year.
Short taxable years are generally included for purposes of determining eligible election years.
The election applies to each member of the group that is included in the group's income tax return for that eligible year, but only for the portion of the eligible year during which such member is a member of the group.
Every member of a consolidated group can receive a cash dividend from a CFC that otherwise qualifies under section 965(a) during any period the recipient is a member of such group. This rule applies even if: (a) as a result of a subsidiary entering or leaving the group, the group's election year is, with respect to the particular subsidiary, neither the taxable year that includes October 22, 2004, nor the subsequent taxable year; or (b) a previous separate return year of the subsidiary also was an election year for the subsidiary. This rule also applies as a result of the acquisition of a consolidated group by an unrelated consolidated group, where the previous separate return year of the acquired group was an election year.
Where a U.S. shareholder leaves a consolidated group and joins another, the selling group includes only cash dividends received by the U.S. shareholder during that part of the year it is a member of that group. Similarly, the acquiring group may only include dividends received by the shareholder while it is a member of the acquiring group.
The selling and acquiring groups are both entitled to elect section 965 for their group years beginning before October 22, 2004, or the first year beginning on or after that date. Thus, the sale of a U.S. shareholder may result in the inclusion of its dividends in taxable years spanning close to two years. For example, if the selling group elected 965 for its taxable year ending September 30, 2004, and sells one of its subsidiary U.S. shareholders on September 1, 2004, to a group that elects section 965 for its taxable year ending July 31, 2005, dividends received by the U.S. shareholder during its short taxable year ending September 1, 2004 are included on the selling group's section 965 calculations and dividends received in the U.S. shareholder's next short taxable year ending July 31, 2005, are included in that group's calculations.
Where a member is sold during a consolidated group's election year and does not join another consolidated group, the sold member may separately elect section 965 for its first short taxable year following the sale, provided that the two periods together do not exceed a year.
C. Reporting. The taxpayer must provide an annual report listing qualified investments attached to Form 8895 for the election year and each successive year until the total eligible cash dividend has been invested(except as provided under the safe harbor described below in section XII(E)).
D. Additional documentation described in section 8.02(b) of Notice 2005-10 must be provided within 30 days of request.
E. Safe Harbor. An administrative safe-harbor is provided in section 8.03 of Notice 2005-10 under which the taxpayer need not report qualifying expenditures after the second year following the election year if:
Expenditures equaling 60% of the total qualifying dividends have been made on permitted investments or are subject to a binding commitment by the end of the second year following the election year.
All annual reporting requirements have been met.
The taxpayer satisfies certain documentation and production requirements and certain representations are made, including that all amounts will be reinvested by the end of the 4th year.
F. If the taxpayer does not satisfy the safe harbor, it must continue to file the necessary reports and may be asked to extend the statute of limitations with respect to section 965 issues. Note that the statute does not provide a time limit for making permitted investments.
XIII. Examination Checklist
A. Review Notice 2005-10, Notice 2005-38. and Notice 2005-64 to become familiar with the provisions.
B. Review Form 8895 filed with the tax return for the election year.
C. Analyze Forms 1118 for the base period years and verify the taxpayer’s calculation of the base period amount, taking into consideration any adjustments required due to restructuring transactions. The base period is the five most recent tax years ending on or before June 30, 2003.
D. Determine if the taxpayer has used the $500.000.000 or the APB 23 limitation as the maximum amount of the qualifying dividend.
E. Review the calculations of the APB 23 amount including any adjustments required due to restructuring transactions.
F. Review the opening and closing balance of related party indebtedness. Determine if adjustments are required to both balances due to restructuring transactions.
G. Review the Domestic Reinvestment Plan noting the date approved by the President, CEO or comparable official. Determine the date the DRIP was approved by the Board of Directors or comparable body.
H. Determine if qualifying dividends were paid after the DRIP was approved by the President or other official.
I. Determine if dividends qualify as cash dividends (Note: taxpayers may specify which dividends are qualifying dividends and which dividends satisfy the base period amount). Qualifying dividends can include amounts paid indirectly from lower-tier CFCs as provided under section 965(a)(2).
J. Review calculations of E&P, PTI, and foreign tax credits of CFCs that pay base period and qualifying dividends.
K. Review calculation of taxable income, the special limitations on deductions and credits and the additional limitations imposed on foreign tax credits.
L. Review documentation regarding expenditures made during the year pursuant to the DRIP to ensure that the expenditures qualify as permitted investments. Review of expenditures may be ongoing in subsequent years.
M. Determine if the taxpayer meets the administrative safe-harbor requirements.