Notice 2005-38 clarifies critical issues.

• Author: Stoffregen, Philip A.
• Position: Repatriation Guidance, part 2

1. Introduction

   Added by the American Jobs Creation Act of 2004, section 965 of the Internal Revenue Code permits U.S. corporations to elect a one-time 85-percent dividends-received deduction for cash dividends received from controlled foreign corporations (CFCs). The election is subject to a number of limitations. Only cash dividends in excess of the average amount paid over a three-year base period are eligible for the deduction. There is an overall ceiling on eligible dividends equal to the greater of $500 million or the amount shown as permanently reinvested outside of the United States on the U.S. shareholder's applicable financial statement. The ceiling amount is reduced by the amount of any increase in CFC related-party indebtedness between the date of the enactment of section 965 and the end of the taxpayer's section 965 election year. Finally, the deduction is available only for dividends earmarked for reinvestment in the United States pursuant to a qualifying dividend reinvestment plan (DRIP).

   In Notice 2005-10, the Internal Revenue Service refined the definition of "cash dividends" and provided guidance concerning the types of investments in the United States for which repatriated funds may be used. Although helpful, this first Notice did not address several key questions. As a result, many taxpayers have been unable to decide whether to take advantage of the provision.

   The two principal uncertainties were the status of the section 78 gross-up amount attributable to the deductible portion of a section 965 dividend (1) and the effect of mergers and acquisitions, during and prior to the section 965 election year, on both the base-period dividend and APB 23 ceiling amounts. Many taxpayers found it impossible to evaluate the new law in the absence of guidance on these issues.

   Issued by the IRS on May 10, 2005, Notice 2005-38 is the much-anticipated second round of guidance on the mechanics of the section 965 temporary dividends-received deduction. The Notice resolves the section 78 issue and addresses the effect of various merger and acquisition transactions on the base-period amount, the ceiling on eligible dividends, and the related-party indebtedness rules. Notice 2005-38 also addresses other miscellaneous, but important, issues, including the disallowance of expenses related to the deductible portion of the eligible dividend, and the application of the alternative minimum tax in the year of election. At least one more round of guidance is expected in the summer of 2005, covering issues relating to the foreign tax credit and expense allocation.

2. Clarification of Section 78 Gross-up and Other Issues

   1. Section 78 gross-up. Section 9 of Notice 2005-38 provides guidance on several areas of great interest to taxpayers. First, and most important, the Notice provides that "[s]ection 78 does not apply to any tax which is not allowable as a credit under section 901 by reason of section 965(d)," thus effectively adopting the approach taken in the pending Technical Corrections Bill. (2) It is somewhat unorthodox for the Treasury Department to promulgate guidance contradicting a provision of the Code, but apparently the urgency of providing taxpayers with guidance, combined with assurances from congressional tax-writers that the pending technical correction legislation reflects their original intent, (3) were considered to provide sufficient justification.

   2. Directly allocable expenses. Another issue addressed in the pending Technical Corrections Bill is the extent to which expenses must be allocated to the deductible portion of a section 965 dividend. Section 965(d)(2) provides that "[n]o deduction shall be allowed for expenses properly allocated and apportioned to the deductible portion...." The bill would amend section 965(d) "by striking 'properly allocated and apportioned' and inserting 'directly allocable.'"

      Again, Notice 2005-38 adopts the pending technical correction: "The disallowance of expenses in section 965(d)(2) applies only to expenses that are "directly allocable" to the deductible portion...." While helpful, this language leaves open how to determine which expenses are directly allocable for this purpose. (4) Further guidance is anticipated on this point.

   3. AMT taxpayers. Section 965(e)(1)(B) provides that any tax imposed on the nondeductible portion of a CFC dividend will not be treated as a regular corporate income tax for purposes of determining the recipient's alternative minimum tax. The statute arguably requires that AMT taxpayers must pay both regular tax and AMT on the nondeductible portion of section 965 dividends, raising the cash tax cost from 5.25 percent to 8.25percent. IRS representatives, however, previously stated that they did not agree with this interpretation, and the Notice provides that AMT taxpayers will not be subject to the AMT with respect to any portion of section 965 dividends. (5)

   4. Election by DRIP. A domestic reinvestment plan may provide for the investment in the United States of an amount that is less than the entire amount of cash dividends that are otherwise eligible for the section 965(a) DRD. In such a case, the section 965(a) DRD applies only to the amount of eligible dividends that are reinvested pursuant to the plan (assuming that all the other requirements under section 965 are satisfied). This language suggests that taxpayers may elect which eligible dividends will be subject to the section 965 DRD by specifically identifying dividends in their DRIP and making no provision for reinvestment of other eligible dividends.

   5. Cross-chain section 304 transactions. Section 9.04 clarifies that a CFC dividend received as a result of a cross-chain section 304 transaction will qualify as an eligible dividend, ending any concern that the dividend recipient's lack of direct ownership in the acquiring entity might prevent the dividend from qualifying for the DRD. (6)

   6. Dividends to disregarded entities. Section 9.06 clarifies the circumstances in which a CFC cash dividend to a foreign disregarded subsidiary of a U.S. shareholder qualifies as a cash dividend to the U.S. shareholder. Notice 2005-10 provided that receipt of cash by a disregarded entity does not constitute receipt of the cash by the U.S. shareholder that owned the disregarded entity unless the disregarded entity in turn distributed the cash to the U.S. shareholder. This is a significant issue for taxpayers that would be subject to foreign withholding tax on dividends paid by the disregarded entity. Notice 2005-38 significantly narrows this rule, providing that the disregarded entity need not distribute the cash so long as the U.S. shareholder receives the cash and has no legal obligation to repay the cash to the disregarded entity. This allows disregarded entities to repatriate cash via repayment of shareholder loans or purchases of assets, thereby avoiding the imposition of foreign withholding tax, 85 percent of which will never be creditable.

3. Effect of M&A Transactions on a Domestic Reinvestment Plan

   Section 4 of Notice 2005-10 provides that a DRIP must describe planned investments in reasonable detail and specificity, state the total amount that will be invested for each principal investment in the United States, and describe the time period over which the investment will be made. A DRIP may encompass more than one cash dividend from one or more CFCs, or the taxpayer may adopt separate DRIPs to apply to different cash dividends received during the election year. Alternative investments may be provided. Notice 2005-10 does not require that a DRIP state from which specific CFCs the cash dividends will be received, or which U.S. shareholder will receive such dividends, nor does it require segregation or tracing of funds. (7)

   Section 8 of Notice 2005-38 takes a flexible approach in addressing how a DRIP may be satisfied following a change to the consolidated group during or after the year of election. Section 8 also specifies which company is responsible for fulfilling the reporting and administrative requirements outlined in Notice 2005-10 when such a change occurs.

   1. Electing Consolidated Group--Member Entering or Exiting. Section 8 provides that a member entering or exiting a consolidated group on or after the first day of the consolidated group's election year can fulfill the investment obligation of the consolidated group. This rule applies "regardless of the amount of cash or property held by the former member or new member at the time it leaves or joins the consolidated group."

      Based on this permissive language, a consolidated group could sell the stock of one of its members on the first day of its election year, even before the election was approved and the cash dividend received, and the exiting member could still fulfill the investment obligation of its former group. The exiting member could fulfill the investment obligation of its former group whether it receives cash dividends from its CFCs before it exits the group, after it exits the group, or not at all. In fact, even if the exiting member is not a U.S. shareholder to one or more CFCs, it is still permitted to fulfill the investment obligation of its former group.

      Similarly, a new member that joins the consolidated group during or after the consolidated group's election year may fulfill the investment obligation of the consolidated group. Because there is no requirement that the taxpayer trace or segregate the cash dividends received from CFCs, the new member may fulfill the acquiring group's investment obligation with the proceeds of cash distributions from CFCs that it owned prior to joining the consolidated group, with the proceeds of cash dividends from CFCs of the consolidated group that it is joining, or with proceeds from other sources, such as its own domestic operations.

      Notice 2005-38 provides that when a former member of the consolidated group fulfills the investment obligation of the consolidated group, in...