New regulations for subpart F and CFC investment in U.S. property.

• Author: Islam, Adnan
• Position: Controlled foreign corporations

On Nov. 3, 2016, the IRS and Treasury issued final regulations pursuant to Sees. 954 and 956 (T.D. 9792), which generally adopted the proposed regulations and withdrew temporary regulations, both issued on Sept. 2,2015 (REG-155164-09 and T.D. 9733, respectively). The final regulations address the treatment of U.S. properties held by controlled foreign corporations (CFCs) in certain transactions involving partnerships. Additionally, the regulations elaborate on the active rents and royalties exception to the foreign personal holding company income (FPHCI) category of Subpart F income, as well as provide guidance on whether a CFC holds or has investment in U.S. property as a result of certain related-party factoring transactions. Along with the final regulations, the IRS and Treasury issued new proposed regulations under Sec. 956 (REG-114734-16). The final regulations also make obsolete Rev. Rul. 90-112.

Subpart F income FPHCI exception modifications

Under Sec. 954, when a CFC earns FPHCI, which includes passive income such as rents or royalties, the income generally is includible in the CFC's U.S. shareholders' taxable incomes, even if the CFC does not distribute earnings to the U.S. shareholders. Thus, the U.S. shareholders generally cannot defer recognition of the FPHCI. However, an exception exists for so-called active rents and royalties.

The final regulations provide specific guidance on the application of the active royalty exception to the FPHCI rules under Sec. 954. Under the final regulations, royalties are not includible in the U.S. shareholders' taxable income if the royalties are received from a party unrelated to the CFC and are earned from an active trade or business (Regs. Sec. 1.954-2(b)(6)).The IRS and Treasury will deem the royalties to have been received in an active trade or business if they meet either the active development test or active marketing test.

Under the final regulations, the active development test is met if the CFC's officers and employees are (1) engaged in an activity that adds substantial value to the licensed property in question; and (2) regularly engaged in the development, creation, or production of, or acquisition and addition of substantial value to, the property in question (see Regs. Sec. 1.954-2(d)(l)(i)). On the other hand, the active marketing test is also met if (1) the CFC through its own officers or staff of employees located in a foreign country maintains and operates an organization in those foreign countries regularly to engage in the business of marketing, or of marketing and servicing, the licensed property; and (2) that organization is substantial in relation to...