Notice 2005-64 completes the IRS's Section 965 trilogy.

• Author: Stoffregen, Philip A.

Overview

Notice 2005-64, issued August 19, 2005, is the third, and presumably final, notice addressing section 965 of the Internal Revenue Code, which was enacted as part of the American Jobs Creation Act of 2004 (ACJC). Notice 2005-64 supplements Notice 2005-10, (1) which primarily addressed the requirements for domestic reinvestment plans, and Notice 2005-38,2 which primarily addressed the limitations described in section 965(b)(1) ($500 million/APB 23 amount), (2) (base period limitation), and (3) (related party indebtedness) on the amount of dividends eligible for the section 965 dividends received deduction, including the effects of acquisitions, dispositions, and similar transactions on those limitations.

In addition, Notice 2005-64 addresses a number of important but previously unresolved issues, including the allocation and apportionment of expenses in a section 965 election year, the extent to which foreign tax credits and minimum tax credits may be claimed in a section 965 election year, and how to translate to U.S. dollars the section 965 dividends paid in foreign currency. Notice 2005-64 reiterates that regulations incorporating the guidance provided in Notice 2005-10, Notice 2005-38, and Notice 2005-64 will be issued, but it is not clear when this will happen. The IRS also released on August 19, 2005, the final version of Form 8895, which must be filed by taxpayers electing the benefit of section 965(a).

Sections 3 to 10 of Notice 2005-64 contain substantive guidance. Section 3 provides rules for identifying cash dividends and qualifying dividends, (3) and for translating certain qualifying dividends. In particular, section 3 makes clear that taxpayers may not specifically identify qualifying dividends as either deductible or nondeductible in whole or in part. It also provides that qualifying section 965 dividends are considered paid pro rata out of the non-previously-taxed earnings and profits in the separate section 904(d)(3)(D) categories from which the dividend was paid. This approach, which was adopted in favor of treating section 965 dividends as a separate limitation category, requires elaboration of the application to section 965 dividends of existing rules for allocating and apportioning expenses to different categories of foreign source income, and for computing and recapturing overall foreign losses and separate limitation losses. This elaboration is supplied in subsequent sections of Notice 2005-64.

Section 4 provides guidance on section 965(d)(1), which disallows any credit or deduction for foreign taxes paid or accrued with respect to the deductible portion of section 965 dividends, and on related issues arising under section 78.

Section 5 provides guidance for applying section 965(d)(2), which disallows deductions for expenses directly allocable to the deductible portion of section 965 dividends. Most important, this section confirms that expenses that do not relate directly to generating qualifying dividends are not subject to disallowance. Such protected expenses include interest, R&D, G&A, and state and local taxes. In contrast, stewardship expenses are treated as directly allocable to qualifying dividends and are, therefore, subject to partial disallowance.

Section 6 provides rules for allocating and apportioning deductions related to section 904(d) separate categories that contain qualifying dividends. These rules are quite harsh, and may have serious adverse consequences for taxpayers that filled their base period amounts with high-taxed CFC dividends, while claiming the section 965 dividends-received deduction (DRD) with respect to low-taxed dividends.

Section 7 contains rules designed to ensure that taxpayers claiming the section 965 DRD do not reduce their taxable income below the amount of their nondeductible qualifying dividends. (4)

Section 8 addresses the application of the overall foreign loss and separate limitation loss allocation and recapture rules of section 904(f) to taxpayers that elect to claim the section 965 DRD.

Section 9 provides rules implementing section 965(e)(1), which limits the use of credits to offset U.S. tax on nondeductible CFC dividends, in part through the application of an additional foreign tax credit limitation that is applied after expenses and losses are allocated and the regular section 904(d) limitation is calculated. Section 9 also explains how taxpayers claiming the section 965 DRD are to compute their alternative minimum tax for the election year, and provides rules for computing the credit for prior year minimum tax that may be applied against otherwise payable regular tax on the nondeductible portion of section 965 dividends.

Section 10 addresses other issues arising under section 965. The most significant of these relate to the related party indebtedness (RPI) limitation of section 965(b)(3). For this purpose, Notice 2005-38 provides a new exception for CFC indebtedness arising in the ordinary course of business as a bank or as a dealer in securities that would not be treated as U.S. property under section 956(c)(2)(A)(i), (J), (K), or (L) were it an obligation of a U.S. person (and not of the CFC). Notice 2005-38 also expands the exception for trade payables provided in Notice 2005-38, providing that the term "indebtedness" does not include indebtedness of a CFC arising in the ordinary course of a business from licenses, provided that such indebtedness is actually paid within 183 days.

The technical rules of sections 3, 4, 6, 7, and 9 of the Notice are illustrated by numerous detailed examples, which in some cases clarify or expand upon the rules they illustrate. These examples should prove valuable in understanding and applying Notice 2005-64.

Like the two Notices that preceded it, Notice 2005-64 provides transition rules, contained in section 11, permitting taxpayers to modify pre-August 19, 2005, dividend reinvestment plans to conform to the new Notice.

Analysis

Section 3: Dividend Identification and Currency Translation

Cash distributions eligible for the section 965 DRD may be received from entities other than the CFC that paid a qualifying cash dividend; namely, disregarded entities, partnerships, and CFCs that, pursuant to Code [section] 965(a)(2), distribute as previously taxed income dividends received from a lower tier CFC. Notice 2005-64, Section 3.01 defines the term "eligible cash amount" as cash received by a U.S. shareholder on any day in the election year from a partnership or disregarded entity, and cash distributions of previously taxed income (PTI) to the U.S. shareholder on any day in the election year from a CFC. Taxpayers that receive eligible cash amounts in excess of the amount of qualifying dividends received by the distributing intermediary entity may specifically identify which such distributions are to be associated with the underlying qualifying CFC dividends. Such identification is to be made on Part V of Form 8895. In the absence of specific identification, a pro rata portion of each eligible cash amount will be associated with the underlying qualifying CFC dividends. (5) Similarly, taxpayers that receive eligible cash amounts aggregating less than the underlying qualified CFC dividends may specifically identify which underlying dividends are to be treated as the source of the eligible cash amounts. Again, the election is made on Part V of Form 8895.

The AJCA conference report provides that taxpayers may specifically identify which CFC dividends they wish to treat as subject to section 965. (6) The planning flexibility thereby granted to taxpayers has been unclear, with some commentators even suggesting that taxpayers could specifically identify some dividends as constituting the 15-percent nondeductible portion of total section 965(a) dividends, and other dividends as constituting the 85-percent deductible portion. (7) This degree of flexibility would have allowed taxpayers to designate high-taxed dividends not only to fill the base period amount, but also to make up the taxable portion of the total qualifying dividend amount. Alas, Notice 2005-64 makes no provision for designating qualifying dividends as either deductible or nondeductible. Instead, it provides that each eligible CFC dividend must be identified in its entirety as either in or out of section 965, with the sole exception that one dividend may be identified as partially in and partially out, to the extent necessary to avoid having the aggregate amount of identified section 965 dividends exceed the total amount eligible for such treatment. (8) Again, if a taxpayer fails to identify specific cash dividends equal to the full amount of qualifying dividends, a pro rata portion of each cash dividend received by the taxpayer during the election year that is not otherwise identified by the taxpayer as a qualifying dividend is treated as a qualifying dividend.

Qualifying dividends from a CFC will be treated as paid pro rata out of the non-previously-taxed earnings and profits in that CFC's separate categories, pursuant to section 904(d)(3)(D). Dividends qualifying under section 965(a)(2) will be treated as paid out of the previously-taxed earnings and profits account of the first-tier CFC attributable to the amount included in the U. S. shareholder's income in the election year as a result of the CFC-to-CFC cash dividend described in section 965(a)(2). Importantly, the subpart F inclusion in this case will reflect the earnings and profits and tax pools of the higher-tier CFC, not the separate earnings and tax pools of the lower-tier payor CFC. (9)

Notice 2005-64, [section] 3.03 provides:

The DRD [dividends-received deduction] allowed under section 965(a) is definitely related to and allocated to reduce gross income in the U.S. shareholder's separate categories to which the qualifying dividends described in section 965(a)(1) and the subpart F inclusions underlying qualifying dividends described in section 965(a)(2) are assigned...