Issues involving the interplay of subpart F income recapture account and sec. 956 inclusion.

• Author: Weeden, Treavor

Under Secs. 951-964, certain income of a controlled foreign corporation (CFC), referred to as Subpart F income, is included in the income of its U.S. shareholders as earned before the income is actually distributed to the U.S. shareholders. Sec. 952(c)(1)(A) limits this Subpart F income inclusion by the U.S. shareholders to the extent of the CFC's current-year earnings and profits (E&P).

When a Subpart F income inclusion is limited by the CFC's current-year E&P, Sec. 952(c)(2) requires establishment of a recapture account whereby Subpart F income is recaptured in subsequent years during which the CFC has current-year E&P exceeding Subpart F income. Specifically, if Subpart F income was reduced by Sec. 952(c)(1)(A), any excess of the CFC's E&P in a subsequent tax year over its Subpart F income for that year is recharacterized as Subpart F income.

Regs. Sec. 1.952-1(f) provides that the amount of Subpart F income in each separate category of income (as defined in Regs. Sec. 1.904-5(a)(1), which refers to Sec. 904(d)(1)) that is reduced by Sec. 952(c)(1)(A) constitutes a recapture account. In any subsequent year in which E&P exceeds Subpart F income, the recapture account in each separate category will be recharacterized, on a proportionate basis, as Subpart F income to the extent of the excess. An amount that is recharacterized is treated as income in the same separate category as the recapture account from which it was derived. Under Regs. Sec. 1.952-1(f)(2)(iii), each recapture account (and post-1986 undistributed earnings for calculating foreign tax credits) will be reduced either (1) by amounts recaptured or (2) by "any distribution" out of that account (as determined under the ordering rules of Sec. 959(c) and Regs. Sec. 1.952-1(f)(3)(ii)).

A question arises as to whether the Subpart F income recapture account is reduced when the CFC has a Sec. 956 investment in U.S. property that causes its shareholder to have a Sec. 956 inclusion in a subsequent year before the Subpart F income recapture account is fully recaptured. Although treated from a policy perspective as a disguised dividend, a Sec. 956 inclusion is not literally a distribution or a dividend. In addition, the preamble to the proposed Sec. 952 regulations makes it clear that the distribution referred to in Regs. Sec. 1.952-1(f) means an actual distribution:

Under paragraph (f), a recapture account is reduced either when amounts in the account are recharacterized as Subpart F...