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

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.
   See Treas. Reg. section 1.861-8(a)(2) and (b)(2).

A subsequent example makes clear that the DRD is allocated exclusively against qualifying dividends in each category. (10)

Notice 2005-64, [section] 3.04 adopts a special rule for translating foreign currency (11) qualifying dividends other than qualifying dividends paid directly from a CFC to a U.S. shareholder under section 965(a)(1). (12) Thus, the special rule applies only to amounts received from a disregarded entity or a partnership, and amounts received from a CFC pursuant to section 965(a)(2) (special rule for PTI attributable to lower-tier CFC qualifying dividends). Because this rule differs from the normal rule for translating CFC dividends, taxpayers should review its potential effect before determining which dividends to identify as qualifying dividends. (13)

Qualifying cash dividends received by a U.S. shareholder from a partnership or disregarded entity are translated from the functional currency of the payor CFC into U.S. dollars at the spot rate on the date the cash dividend is actually received by the U.S. shareholder, rather than at the spot rate on the date the dividend is received by the partnership or disregarded entity. (14) Similarly, subpart F inclusions that result in qualifying cash dividends pursuant to section 965(a)(2) will be translated to dollars from the functional currency of the CFC that receives the lower-tier CFC dividend that creates the PTI at the spot rate on the date the PTI is distributed to the U.S. shareholder, rather than at the average rate generally used to translate subpart F inclusions. As a result, neither the U.S. shareholder that receives a distribution of PTI nor the distributing CFC will realize currency gain or loss on the distribution of PTI under section 965(a)(2). (15)

Dividends received during the election year that are not subject to section 965(a)(1) are subject to the normal translation rules.

Section 4: Identifying Foreign Income Taxes Paid or Accrued with Respect to the Deductible Portion of Qualifying Dividends

Section 965(d)(1) provides that no credit or deduction is allowed for foreign income taxes paid or accrued with respect to the deductible portion of each qualifying dividend. Section 4.01 of Notice 2005-64 confirms that, notwithstanding the disallowance of any benefit for such credits, post-1986 undistributed earnings, post-1986 foreign income taxes, pre-1987 accumulated profits, pre-1987 foreign income taxes, previously-taxed earnings and profits, and tax accounts of CFCs paying qualifying dividends are reduced by the full amount of earnings distributed and the full amount of foreign taxes attributable to the distributed earnings, without regard to the amount of the DRD or the amount of foreign tax for which section 965(d)(1) disallows a credit or deduction. Section 4.02 confirms that section 78 does not apply to any foreign income tax that is not allowable as a credit by reason of section 965(d). (16)

Section 5: Disallowance of Deductions for Expenses Directly Related to Deductible Portion of Qualifying Dividends

Section 965(d)(2) disallows a deduction for 85 percent of expenses directly related to qualifying dividends. According to Notice 2005-64, the following exclusive list of expenses (17) are subject this rule: (1) stewardship expenses described in Treas. Reg. [section] 1.861-8(e)(4) that are definitely related and allocable to qualifying dividends; (18) (2) legal, tax, accounting, consulting, and similar fees and expenses for advice and documents directly related to qualifying dividends, including the determination of the potentially eligible amount of qualifying dividends, the decision to repatriate earnings from particular CFCs, the identification of particular distributions as cash dividends, qualifying dividends, or other amounts, the adoption and approval of a domestic reinvestment plan, and the declaration and payment of qualifying dividends; (3) fees and expenses related to tax accounting and reporting for qualifying dividends in the election year; and (4) wire transfer, currency exchange, and similar fees incurred in connection with the payment of qualifying dividends. (19) Deductions for these directly related expenses are subject to disallowance in the year paid or accrued, whether that year is the election year or a different taxable year, except that only stewardship expenses paid or accrued in the election year are subject to disallowance.

Deductions directly related to the allowable 15 percent of directly allocable expenses are allocated and apportioned in accordance with the rules of sections 861 through 865, as clarified in Notice 2005-64, [section] 6.

Section 6: Allocation and Apportionment of Expenses To Separate Categories with Qualifying Dividends

Notice 2005-64 provides that there is no separate foreign tax credit limitation basket for qualifying dividends. Instead, the normal section 904(d)(3) foreign tax credit basket look-through rules apply to determine the separate category to which qualifying dividends are assigned. For purposes of allocating and apportioning deductions, stock in CFCs that pay qualifying dividends is characterized under the generally applicable rules of Temp. Reg. [section] 1.861-12T(c)(3).

Section 864(e)(3) provides that a portion of any dividends qualifying for a DRD under section 243 or 245(a) are not taken into account for purposes of allocating and apportioning deductible expenses. Notice 2005-64 confirms that this special rule does not apply to qualifying dividends that receive a dividends received deduction under section 965. (20)

In a major surprise, Notice 2005-64 provides an ordering rule for allocating and apportioning expenses and losses to separate categories that include nondeductible CFC dividends. Expenses that are allocated and apportioned to a separate category that includes qualifying dividends first reduce other foreign source gross income in the separate category before reducing foreign source income attributable to nondeductible CFC dividends. If expenses and other deductions properly allocated and apportioned to foreign source gross income in a separate category exceed the amount of foreign source gross income exclusive of nondeductible CFC dividends in that category, the excess reduces nondeductible CFC dividends in the separate category, and any excess constitutes a section 904(f)(5) separate limitation loss. (21)

This rule will result in deferral and/or loss of foreign tax credits for taxpayers that chose to repatriate high-taxed foreign earnings to fill the section 965(b)(2) base period amount, and elected the benefit of section 965 for low-taxed foreign earnings. An example provided in Notice 2005-64 can be used to illustrate the problem.

(i) Facts. USP has the following items of gross income and expense for the election year: $1,200 of foreign source general limitation gross income, including $1,000 of qualifying dividends, $1,000 of expenses allocated and apportioned to general limitation income (including the 85-percent DRD of $850, which pursuant to section 3.03 of Notice 2005-64 is allocated to reduce general limitation income), $300 of U.S. source gross income, and $100 of expenses allocated and apportioned to U.S. source income. Accordingly, USP has $400 of taxable income and $150 of nondeductible CFC dividends in the election year, and the taxable income limitation of section 965(e)(2)(A) does not apply. [After allocation of the $850 section 965 DRD, USP thus has $200 of net general limitation income, consisting of $150 on nondeductible CFC dividends, $200 of other general limitation income, and $150 of general limitation expenses.]

(ii) Result. Under section 6.03 of Notice 2005-64, general limitation expenses are considered to reduce other general limitation income before reducing nondeductible CFC dividends. Accordingly, USP has $200 of foreign source general limitation taxable income, of which $150 is attributable to nondeductible CFC dividends, and $200 of U.S. source taxable income. (22) [Thus, all general limitation expenses other than the $850 DRD are allocated to other general limitation income.]

Prior to issuance of Notice 2005-64, most taxpayers would have assumed that the $150 of expenses allocable to general limitation income would be allocated ratably between the $150 taxable portion of the qualifying dividends and the $200 of other general limitation gross income, with the result that 150/350 of the expenses, or $64.3, would have been allocated against the qualifying dividend and 200/350, or $85.7, would have been allocated against other general limitation gross income. On this approach, the taxpayer in the example would have had $114.3 of general basket foreign source income not subject to the special foreign tax credit limitation of section 965(e)(1), as compared with only $50 under Notice 2005-64. This reduces USP's foreign tax credit utilization in the election year by $22.50 ($64.3 X 35%) as opposed to the foreign tax credit result it probably anticipated under the pro rata allocation method assumed by most taxpayers. Given the lack of any direct support in the statute or the legislative history for the punitive allocation method adopted in Notice 2005-64, the timing of the promulgation of this rule, a full 10 months after enactment of section 965, and after substantial amounts have already been repatriated pursuant to section 965, seems rather unfair.

Section 7: Limitation on Reduction in Taxable Income Below Amount of Nondeductible CFC Dividends Pursuant to Section 965(e)(2)

If deductible expenses and losses for the election year (including the section 965 DRD but not including expenses disallowed pursuant to section 965(d)(2) and Notice 2005-64, [section] 5.01) exceed the taxpayer's gross income, excluding nondeductible CFC dividends, then taxable income equals the amount of nondeductible CFC dividends. Deductions in excess of this amount constitute an NOL for the election year.

Nondeductible CFC dividends may not be reduced by NOL carryforwards or carrybacks. Accordingly, the allowable NOL deduction for the election year is limited to the excess of taxable income over nondeductible CFC dividends. Taxable income attributable to nondeductible CFC dividends, however, is taken into account for purposes of Notice 89-3, [paragraph] 1 (23) in determining the source and allocation of NOL deductions taken into account in the election year.

There is no limitation on using deductions to reduce taxable income in excess of the amount of nondeductible CFC dividends, including income attributable to the section 78 gross-up with respect to foreign taxes deemed paid with respect to nondeductible CFC dividends. (24)

Finally, section 7 provides that, except as set forth in Notice 2005-64, a taxpayer's gross income is considered to include qualifying dividends for purposes of the limitations based on the amount of the taxpayer's gross income for the taxable year. (25)

Section 8: Overall Foreign Loss and Separate Limitation Loss Rules

Pursuant to the rules of Notice 2005-64, [section] 6, except in situations where the taxable income limitation of section 965(e)(2)(A) applies, the section 904(f) foreign loss recapture rules may reduce nondeductible CFC dividends in a separate category, or recharacterize such amount as U.S. source income or foreign source income in a different separate category for purposes of the section 904(d) foreign tax credit limitation. Because taxable income and the allowable NOL deduction for the election year are determined before applying section 904(f), it follows that the amount of the section 965(a) DRD, the amount of foreign taxes and expenses for which a credit or deduction is disallowed under section 965(d), the amount of taxable income determined under section 965(e)(2)(A), and the allowable NOL deduction determined under section 965(e)(2)(B) are not affected if nondeductible CFC dividends are reduced or recharacterized as U.S. source income or foreign source income in another separate category. (26)

Consistent with the approach taken in section 6 of Notice 2005-64, a separate limitation loss or U.S. loss allocated to reduce foreign source taxable income in a separate category that includes nondeductible CFC dividends is considered first to reduce other foreign source income in the separate category before reducing foreign source income attributable to nondeductible CFC dividends. Thus, if nondeductible CFC dividends in the general limitation category are reduced, income in a later year in a different category, or domestic source income, that is recharacterized under section 904(f)(5)(C) or (f)(1) as income in the general limitation category will increase the limitation available in the general limitation category for income other than nondeductible CFC dividends. (27) Thus, in this case the limitation generated by nondeductible CFC dividends may be used in a subsequent year to absorb excess credits attributable to other income. (28) The rule requiring allocation of a specified loss liability (SLL) or U.S. loss first to other foreign source income in a category that also contains nondeductible CFC dividends serves to minimize the amount of limitation attributable to the nondeductible CFC dividends that may latter be used against excess credits on other income.

A taxpayer that would have a taxable loss but for receiving nondeductible CFC dividends in its election year may have separate limitation income attributable to nondeductible CFC dividends, with or without a separate limitation loss in the same separate category, and may have separate limitation income or separate limitation losses in other separate categories, as well as U.S. source taxable income or loss. Because separate limitation losses and U.S. losses in the aggregate may not reduce the sum of separate limitation income and U.S. source income below the amount of nondeductible CFC dividends in the election year, the excess of such losses over the amount of income exclusive of nondeductible CFC dividends constitutes a net operating loss for the election year. In this case, the determination of which losses are absorbed in the election year and which make up the net operating loss in the election year, separate limitation losses, and U.S. losses is made pursuant to sections 904(f)(5)(B) and (D), without regard to nondeductible CFC dividends. (29)

If, after the allocation of losses described in the preceding paragraph, limitation is left in a separate category containing nondeductible CFC dividends, the generally applicable loss recapture rules of section 904(f) may require income in that basket to be recharacterized as income in another separate category or as U.S. source income. Such recharacterization will be required if the taxpayer had separate limitation losses in that same separate category in a prior taxable year that were allocated to reduce separate limitation income in another separate category or U.S. source income. Again, separate limitation losses and overall foreign losses with respect to a separate category that includes nondeductible CFC dividends are recaptured first out of other income in the separate category before any income attributable to nondeductible CFC dividends is recharacterized. (30) If nondeductible CFC dividends are recharacterized as U.S. source income or income in a different separate category, the recharacterized income in that other category is not subject to the special limitations applicable to nondeductible CFC dividends. (31) Any foreign tax attributable to the nondeductible CFC dividends so recharacterized, however, remains in its original separate limitation basket, (32) whereas foreign tax attributable to nondeductible CFC dividends may be carried forward and used against non-qualifying income in the same separate category. (33)

Section 9: Restriction on Use of Credits to Offset Tax on Nondeductible CFC Dividends and Computation of Alternative Minimum Tax Pursuant to Section 965(e)(1)

According to Notice 2005-64, section 965(e)(1) provides that pre-credit U.S. tax that is attributable to nondeductible CFC dividends may not be offset by any credit other than prior year minimum tax credits and a foreign tax credit for foreign income taxes attributable to the nondeductible CFC dividends. (34) Notice 2005-64 therefore adopts "an additional foreign tax credit limitation for each separate category that includes nondeductible CFC dividends." This additional limitation is applied after U.S. source taxable income and foreign source taxable income in the separate categories are determined, (35) after the allocation of separate limitation losses, overall foreign losses, and U.S. losses, and recapture of overall foreign losses and separate limitation losses pursuant to section 904(f), (36) and after determining the section 904 limitation for each separate category that contains nondeductible CFC dividends.

The special additional foreign tax credit limitation is applied by first determining the "modified section 904 limitation" for each separate limitation category, by subtracting the amount of nondeductible CFC dividends in the separate category from both the numerator and denominator of the regular section 904 limitation fraction and subtracting the pre-credit U.S. tax attributable to the nondeductible CFC dividends in the separate category (37) from the pre-credit U.S. tax used in the regular section 904 limitation calculation. The section 965(e) limitation then equals the sum of creditable foreign taxes paid or accrued with respect to the nondeductible CFC dividends in the separate category plus the modified section 904 limitation for that separate category. (38) If the separate category in question includes nondeductible CFC dividends that were reduced by deductions or recharacterized as U.S. source or income in a different category under section 904(f), the amount of nondeductible dividends in the separate category is the amount remaining, and only taxes attributable to that remaining amount are taken into account for purposes of computing the section 965(e)(1) limitation. Taxes in the separate category are then limited to the lesser of the regular foreign tax credit limitation or the section 965(e) limitation.

The special section 965(e) limitation will apply only where nondeductible CFC dividends in a separate category bear a lower effective foreign tax rate than other income in the category, and the effective foreign tax rate on the other income exceeds the taxpayer's U.S. tax rate.

The section 965(e) limitation does not prevent excess credits attributable to nondeductible CFC dividends from being cross-credited against other foreign source income, including the section 78 gross-up for foreign taxes deemed paid with respect to nondeductible CFC dividends. (39)

The residual U.S. tax, after allowable foreign tax credits, on nondeductible CFC dividends may be further reduced only by the section 53 credit for prior year minimum tax. (40) A taxpayer's regular tax and tentative minimum tax are computed taking into account the regular tax and tentative minimum tax on nondeductible CFC dividends, as reduced by allowable foreign tax credits. (41) Therefore, credits for prior year minimum tax may reduce the regular tax on nondeductible CFC dividends and other income even if the taxpayer's entire taxable income is attributable to nondeductible CFC dividends or if the taxpayer is subject to AMT on taxable income other than nondeductible CFC dividends in the election year. Because section 53(c) provides that AMT credits offset only regular tax in excess of the AMT for the taxable year, AMT credits cannot reduce the tax rate on qualifying dividends below 3 percent. (42)

In computing AMT for the election year, a taxpayer's regular tax does not include the portion of the taxpayer's pre-credit regular tax liability that is attributable to nondeductible CFC dividends, and the foreign tax credit taken into account does not include the portion of the taxpayer's allowable foreign tax credit that is attributable to nondeductible CFC dividends. (43) Similarly, the taxpayer's tentative minimum tax does not include the portion of the taxpayer's tentative minimum tax or alternative minimum tax foreign tax credit that is attributable to nondeductible CFC dividends. In addition, the deductible portion of qualifying dividends is not treated as a preference item in computing alternative minimum taxable income. Accordingly, any AMT due in the election year is the same that would have been due if the qualifying dividends had not been paid. (44)

Section 10: Other Guidance

Notice 2005-64, [section] 10 provides guidance on miscellaneous, but important, open issues. Section 10.01 reiterates that, unless otherwise specifically provided, general tax law principles such as circular cash flow, substance over form, and step-transaction, apply to section 965, but provides no further insight. The brevity of this paragraph is disappointing, since many taxpayers are grappling with the application of tax law principles, especially circular cash, to section 965. These issues primarily arise in the context of the section 965(b)(3) limitation on related person indebtedness (RPI).

In one common fact pattern, USP is indebted to CFC1, and would like to satisfy its obligation to CFC1 in cash (step 1) with the intention that CFC1 will immediately loan the cash to CFC2 (step 2), which will use the loan proceeds to pay a section 965 dividend to USP (step 3). On a hyper-strict interpretation of the circular cash flow doctrine, this three step transaction is subject to recast as a two step transaction in which CFC1 transfers its USP note to CFC2 in exchange for a CFC2 note (step 1), and CFC2 then distributes the note to USP (step 2), with the note thereby ceasing to exist. Published and private rulings, however, typically apply the circular cash doctrine only where either (i) the circle of cash results in no net economic effect, (45) or (ii) circular cash analysis is applied to determine the applicability of a non-recognition provision. (46) Hence, absent any special anti-abuse rules under section 965, taxpayers would seem to have a reasonable argument that their choice of form should prevail in this fact pattern.

The AJCA conference report explains the purpose of section 965(b)(3), as follows:

   The amount of dividends eligible for the deduction
   is reduced by any increase in related-party
   indebtedness on the part of a controlled foreign
   corporation between October 3, 2004 and the close
   of the taxable year for which the deduction is being
   claimed, determined by treating all controlled
   foreign corporations with respect to which the
   taxpayer is a U.S. shareholder as one controlled
   foreign corporation. This rule is intended to prevent
   a deduction from being claimed in cases in
   which the U.S. shareholder directly or indirectly
   (e.g., through a related party) finances the payment
   of a dividend from a controlled foreign corporation.
   In such a case, there may be no net repatriation
   of funds, and thus it would be inappropriate to
   provide the deduction. (47)

The use of the word "finances" in the conference report, given the context, suggests that the drafters thought section 965(b)(3) applied only to the use of related party loans to fund 965 dividends. Accordingly, regulatory authority to enforce the purpose of section 965(b)(3) presumably would not extend to recharacterizing transactions that by definition could have no effect on the RPI analysis. (48)

The revised technical correction bill issued on July 21 (49) states that cash dividends are not eligible for the DRD to the extent "attributable" to direct or indirect transfers of cash "including capital contributions." The relevant language in the July 21 Explanation provides:

   The provision also provides the Treasury Secretary
   with explicit regulatory authority to prevent the
   avoidance of the purposes of Code section 965(b)(3),
   which reduces the amount of eligible dividends in
   certain cases in which an increase in related-party
   indebtedness has occurred after October 3, 2004.
   Regulations issued pursuant to this authority may
   include rules to provide that cash dividends are not
   taken into account under Code section 965(a) to the
   extent attributable to the direct or indirect transfer
   of cash or other property from a related person to
   a controlled foreign corporation (including through
   the use of intervening entities or capital contributions).
   It is expected that this authority, which
   supplements existing principles relating to the
   treatment of circular flows of cash, will be used
   to prevent the application of the deduction in the
   case of a dividend that is effectively funded by
   the U.S. shareholder or its affiliates that are not
   controlled foreign corporations. It is anticipated
   that dividends will be treated as attributable to
   a related-party transfer of cash or other property
   under this authority only in cases in which the
   transfer is part of an arrangement undertaken with
   a principal purpose of avoiding the purposes of the
   related-party debt rule of Code section 965(b)(3).
   ... A transfer by a U.S. shareholder in repayment
   of an obligation owed to a controlled foreign corporation
   will not be considered to have a principal
   purpose of avoiding the purposes of Code section
   965(b)(3), absent special circumstances indicating
   that the U.S. shareholder is using the repayment
   effectively to fund the dividend repatriation. It is
   expected that these special circumstances would
   not be found to exist in cases involving the repayment
   of short-term debt (i.e., debt with a term of
   no more than three years)." (50)

It thus appears that the technical correction to section 965(b)(3) would expand the original "purposes" of 965(b)(3) to catch at least some transfers of cash from a related person to a CFC that do not have the effect of reducing the RPI limitation. Assuming the technical corrections bill is enacted, the "purpose" of paragraph 965(b)(3) can be violated in situations in which there is no related party debt in existence at any time from Sept 30, 2004, to the end of the section 965 election year. The language about applying regulatory authority to protect the purposes of the RPI rule in cases where USP repays a debt to CFC, however, raises as many questions as it answers. What kind of circumstances might indicate that the debt is being repaid for the principal purpose of funding a dividend? Why are those circumstances usually absent when short term debt is repaid?

Taxpayers are thus left in the following uncomfortable position: According to Notice 2005-64, normal substance over form doctrines, including the circular cash doctrine, apply to section 965 planning. It is unclear, however, whether the circular cash doctrine as previously developed applies to fact patterns in which the economic positions of the parties are changed, as where a U.S. taxpayer satisfies a valid debt obligation with cash, which is then used to fund a dividend to the U.S. taxpayer or its U.S. affiliate. Moreover, the "purpose" of the RPI limitation of section 965(b)(3), which, according to the July 21 technical discussion of the revised Technical Corrections Bill, is to guide the determination whether U.S. debt to a CFC may be repaid to provide cash for a qualifying dividend, is currently uncertain, given that the Technical Corrections Bill, which has not yet been enacted, appears to substantially broaden the "purpose" of the RPI limitation as enacted October 2004. This uncertainty is complicating repatriation planning for many taxpayers.

Section 10.02 provides that in determining a taxpayer's base period amount for purposes of section 965(b)(2)(B), dividends received by a disregarded entity or a partnership owned by a U.S. shareholder during a base period year are treated as base period amounts to the extent included in income on the U.S. shareholder's return for the base period year, regardless of whether cash or property in the amount of the dividend was received by the shareholder in the base period year. Similarly, section 956 deemed dividends to domestic partnerships are included in the base period amount of partners to the extent allocated to the U.S. shareholder-partner in a base period year and separately stated to the partner under Treas. Reg. [section] 1.702-1(a)(8)(ii). (51)

The $500 million limitation on qualifying dividends is allocated among the qualified members of a section 52(a) group in proportion to the aggregate amount of total current and accumulated non-previously-taxed earnings and profits of all CFCs owned by such qualified members. Section 10.03 of Notice 2005-64 clarifies that the amount of non-PTI earnings and profits of a CFC taken into account for this purpose by a qualified member is that member's pro rata share of the CFC's earnings and profits, determined in accordance with section 951(a)(2), for the last Form 5471 filed on or before the apportionment date.

Section 10.04 clarifies that the amount of earnings shown on an "applicable financial statement" as permanently reinvested outside the United States is not affected by, or modified to reflect, any post-June 30, 2003, restatement. (52)

Section 10.05 defines the term "United States" to include the territorial waters of the United States and the seabed and subsoil of those submarine areas that are adjacent to the territorial waters of the United States and over which the United States has exclusive rights, in accordance with international law, with respect to the exploration and exploitation of natural resources. The term "United States" does not include possessions and territories of the United States or the airspace over the United States and these areas. This definition is relevant to whether expenditures qualify as eligible investments as defined in Notice 2005-10, [section] 5.

Sections 10.06 through 10.08 relate to the related party indebtedness (RPI) limitation of section 965(b)(3). Section 10.06 provides that accounts payable established under Rev. Proc. 99-32, 1999-2 C.B. 296, in connection with section 482 adjustments are treated as RPI. Section 10.07 provides a new exception to the definition of RPI for indebtedness of a CFC, 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 certain subparagraphs of section 956(c)(2) if it were an obligation of a United States person. (53) This exception applies to CFCs that meet the definition of a bank in section 585(a)(2)(B), (54) and operate under the laws of the foreign jurisdiction where it is engaged in business and is subject to supervision and examination by local banking authorities. Finally, section 10.08 excludes from the definition of RPI any CFC indebtedness that arose in the ordinary course of a business from licenses, provided that such indebtedness is actually paid within 183 days. (55)

Section 10.09 clarifies that the special rule of Notice 2005-38, [section] 9.06, permitting disregarded entities to repatriate qualifying cash dividends via methods other than a distribution, does not apply to partnerships. Accordingly, a cash dividend paid by a CFC to a partnership that is owned by a U.S. shareholder is treated as received by such U.S. shareholder only if and to the extent the partnership distributes cash to the shareholder-partner in the election year. A guaranteed payment, or a payment made to a partner other than in its capacity as a partner, is not treated as a distribution of cash for this purpose.

Section 4.01 of Notice 2005-10 provides that a dividend reinvestment plan (DRIP) may, but is not required to, provide for the reinvestment of cash dividends only from specified CFCs, to the extent of the dollar amounts of anticipated investments that are specified in the DRIP. Section 10.10 provides that in this case, cash dividends from other CFCs in the election year that are not covered by another domestic reinvestment plan are not qualifying section 965 dividends, even if the dollar amount of cash dividends from the specified CFCs is less than the total dollar amount of anticipated investments specified in the plan and if the taxpayer in fact expends the total dollar amount specified in the plan on permitted investments. Once qualifying dividends are identified in a DRIP, however, section 965(a) will apply to all of the qualifying dividends that are covered by a domestic reinvestment plan, up to the amount that are properly reinvested in accordance with the plan. (56) By identifying the specific dividends in the DRIP, the taxpayer loses the ability to defer this decision until the time of the filing of the Form 8895 (which may not occur until 9 months after the election year), when the taxpayer may have more solid information about the E&P and tax pools of its CFCs. On the other hand, identification of specific dividends in the DRIP could prevent section 965 (and the related denial of foreign tax credits and expense deductions) from applying to dividends which the taxpayer did not intend to be subject to the deduction.

Section 10.11 provides that, for purposes of Notice 2005-10, [section] 5.05(b), (57) contributions to a qualified pension plan that do not give rise to the section 4972 excise tax on certain nondeductible pension contributions will be considered to satisfy an obligation to fund a qualified plan even if those contributions are not currently deductible. Contributions to a qualified profit sharing or stock bonus plan also qualify if required under a fixed contribution formula under the terms of the plan. Contributions made on a discretionary basis to a qualified profit sharing or stock bonus plan do not qualify as permitted investments.

Section 11: Transition Rules

DRIPs approved prior to August 19, 2005, may be modified to take Notice 2005-64 into account not later than October 19, 2005, even if the dividend to which the domestic reinvestment plan relates has already been paid. The modified plan must be reapproved by the taxpayer's president, chief executive officer, or comparable official and by the taxpayer's board of directors, management committee, executive committee, or similar body. Tax Returns Filed Prior to August 19, 2005, may be amended through December 31, 2005, to conform to Notice 2005-64.

(1) 2005-6 I.R.B. 474.

(2) 2005-22 I.R.B. 1100.

(3) Notice 2005-64, [section] 2.01 defines the term "qualifying dividends" as "the amount of cash dividends eligible for the section 965(a) DRD."

(4) I.R.C. [section] 965(e)(2)(A) provides that "The taxable income of any United States shareholder for any taxable year shall in no event be less than the amount of nondeductible CFC dividends received during such year."

(5) The pro rata portion is the amount which bears the same ratio to the eligible cash amount as the unidentified portion of the taxpayer's share of the cash dividends paid to the disregarded entity, partnership or CFC bears to the total amount of eligible cash amounts received during the election year but not otherwise identified as cash dividends. See Notice 2005-64, [section] 3.05, Example 3.

(6) H.R. Rep. No. 108-755, 108th Cong., 2d Sess. 316 (2004).

(7) John Kaufmann Effect of Foreign Currency Translation on Repatriation of High-Taxed Foreign Income under The Jobs Act, 107 Tax Notes 471 (April 25, 2005). "A taxpayer that receives dividends from more than one source during the tax year will have two chances to allocate distributions to the nondeductible portion of the excess amount. First, the taxpayer may allocate dividends between the base period amount and the excess amount. Second, the taxpayer may allocate income within the excess amount between the deductible portion and the nondeductible portion thereof [citing H.R.. Rep. No. 108-755, at 316]."

(8) "A taxpayer generally must identify each cash dividend received during the election year as either a qualifying dividend or a non-qualifying dividend in its entirety, but may identify a portion of one dividend as a qualifying dividend to the extent necessary to prevent the total amount identified in Part V, column (e) of Form 8895 from exceeding the total amount of qualifying dividends." Notice 2005-64, [section] 3.02. More explicitly, section 2.02 provides: "the taxpayer may specifically identify which cash dividends are treated as carrying the DRD (and thus entail proportionate disallowance of any associated deductions and foreign tax credits) and which are not. H.R.. Rep. No. 108-755, at 316. (emphasis added)"

(9) This is illustrated in Example 5 of Notice 2005-64, [section] 4.03.

(10) Notice 2005-64, [section] 6.04, Example 1.

(11) "[T]he term 'cash' includes both U.S. dollars and foreign currency." Notice 2005-10, [section] 3.01.

(12) Direct qualifying dividends are translated at the spot rate on date of distribution pursuant to section 989(b)(1).

(13) See Notice 2005-64, [section] 3.05, Example 1.

(14) Presumably this rule applies only where the partnership or disregarded entity both receives and pays cash in the form of the functional currency of the CFC that paid the underlying qualifying dividend. If the intermediate entity receives functional currency from the CFC and immediately converts it to dollars, which are subsequently distributed to the U.S. shareholder as qualifying dividends, it would make no sense to require the U.S. shareholder to use the spot rate on the date of distribution, rather than the spot rate on the date of actual conversion to dollars.

(15) See Notice 2005-64, [section] 3.05, Example 6.

(16) See Notice 2005-38, [section] 9.01.

(17) Expenses not listed, and therefore not subject to disallowance, include interest expense, research and experimental expenses, general and administrative expenses, depreciation and amortization, sales and marketing expenses, state and local taxes, and legal, tax, accounting, consulting, and similar fees and expenses related to the implementation of investments in the United States contemplated by a domestic reinvestment plan are not considered directly allocable to qualifying dividends. In addition, deductions for expenses of CFCs that are otherwise deductible in computing subpart F income and earnings and profits are not limited by section 965(d)(2).

(18) Only a pro rata portion of stewardship expenses accrued in the election year with respect to each CFC in which the taxpayer is a U.S. shareholder is considered definitely related and allocable to qualifying dividends. The pro rata portion is the amount that bears the same ratio to the stewardship expenses as the qualifying dividends paid by a CFC bear to the total amount of dividends and subpart F inclusions included in the U.S. shareholder's income with respect to that CFC and subpart F inclusions attributable to stock of any other CFCs held indirectly by the U.S. shareholder in the same section 958(a) chain of ownership in the election year. This pro rata apportionment is done on a CFC by CFC basis, but only after applying the Treas. Reg. [section] 1.861-8(e)(4) rules to determine the amount of stewardship expense allocable to each such CFC. Thus, with respect to a CFC that does not generate a qualifying dividend, no part of the stewardship expense allocable to such CFC should be subject to disallowance under this rule.

(19) Notice 2005-64, [section] 5.01.

(20) Notice 2005-64, [section] 6.02. Similarly, this paragraph of the Notice provides that gross income attributable to a qualifying dividend is not considered exempt income for purposes of section 864(e)(3), so that no portion of the stock of a CFC paying a qualifying dividend is considered an exempt asset for purposes of allocating and apportioning interest and other expenses in the election year.

(21) The allocation and apportionment of expenses is relevant only to determining the section 904 limitation, and the Notice confirms that the amount of the section 965 DRD, the amount of foreign taxes and expenses for which credit or deduction is disallowed under section 965(d), the amount of taxable income determined under section 965(e)(2)(A), and the allowable NOL deduction determined under section 965(e)(2)(B), are not affected if nondeductible CFC dividends in a separate category are reduced or eliminated by reason of the allocation and apportionment of expenses pursuant to sections 861 through 865.

(22) Notice 2005-64, [section] 6.04, Example 1. This example makes clear that the dividends received deduction equal to 85 percent of qualifying dividends is allocated solely against qualifying dividends. This result is obviously reasonable and appropriate, but it is not clear how it follows as a technical matter from the rule that qualifying dividends are categorized under the normal basketing rules, and do not constitute a separate statutory grouping for purposes of the allocation and apportionment rules.

(23) 1989-1 C.B. 623. Paragraph 1 of Notice 89-3 provides ordering rules for carrying forward or backward NOLs for purposes of allocating separate limitation losses, recapturing overall foreign losses, recharacterizing separate limitation income, and allocating U.S. source losses.

(24) Notice 2005-64, [section] 7.05.

(25) Notice 2005-64, [section] 7.03. Likewise, for purposes of provisions that contain limitations based on the taxpayer's taxable income for the taxable year, taxable income includes nondeductible CFC dividends.

(26) Notice 2005-64, [section] 8.01.

(27) Notice 2005-64, [section] 8.02.

(28) Unfortunately, the language in the Notice is obscure, with section 8.02 stating: "Even if nondeductible CFC dividends are reduced as a result of a separate limitation loss or U.S. loss allocation, income in a later year in the separate category that is recharacterized under section 904(f)(5)(C) or section 904(f)(1) as income in the loss category or as U.S. source income, as the case may be, will not be considered nondeductible CFC dividends."

If general basket nondeductible CFC dividends were reduced by a passive SLL or U.S. loss, however, future passive income or U.S. source income would be recharacterized as general basket under section 904(f)(5)(C) or (g)(1), whereas the quoted text seemingly assumes that future general basket income would be recharacterized as passive or U.S. income. No examples are provided to illustrate this rule, but Example 7 of section 8.05 supports the interpretation in the text. In addition, a representative of the IRS has informally confirmed the foregoing interpretation, clarifying that the language in the first paragraph of section 8.02 will be revised accordingly.

(29) This rule is illustrated in Examples 3 and 4 of section 8.05.

(30) Notice 2005-64, [section] 8.03.

(31) See Notice 2005-64, [section] 8.05, Examples 5, 6, and 7.

(32) Rules relating to the application of section 965(e)(1) to foreign taxes attributable to nondeductible CFC dividends when a portion of nondeductible CFC dividends is recharacterized under section 904(f) are provided in section 9.02 of Notice 2005-64, and are in the text that follows.

(33) Notice 2005-64, [section] 9.02(b).

(34) The statute as enacted does not so provide. Pending Technical Corrections, however, as described in the Joint Committee description of the Technical Corrections bill, will clarify that "the only foreign tax credits that may be used to reduce the tax on the nondeductible portion of a dividend are credits for foreign taxes that are attributable to the nondeductible portion of the dividend. Credits for other foreign taxes cannot be used to reduce the tax on the nondeductible portion of the dividend."

(35) This determination is made pursuant to sections 6 and 7 of Notice 2005-64.

(36) These determinations are made pursuant to section 8 of Notice 2005-64.

(37) The pre-credit U.S. tax attributable to nondeductible CFC dividends in a separate category equals 35 percent (20 percent for alternative minimum tax purposes) of the amount of nondeductible CFC dividends in that category.

(38) See Notice 2005-64, [section] 9.02(c), Examples 1 through 4.

(39) Notice 2005-64, [section] 9.02(b).

(40) I.R.C. [section] 965(e)(1).

(41) Notice 2005-64, [section] 9.04.

(42) See Notice 2005-64, [section] 9.06, Examples 3 through 6.

(43) Notice 2005-38, [section] 9.01: "For purposes of calculating alternative minimum tax for the election year under section 55(a) in accordance with section 965(e)(1)(B), the taxpayer's regular tax described in section 55(c) and tentative minimum tax determined under section 55(b)(1)(B) do not include tax attributable to nondeductible CFC dividends."

(44) See Notice 2005-64, [section] 9.06, Examples 1, 2, 4 and 5.

(45) See LTR 200135020 (P contributes $X to Sub and Sub immediately distributes $X to P).

(46) Rev. Rul. 83-142, 1983-2 C.B. 68. See also Treas. Reg. [section] 1.1032-3, which addresses the zero basis issue in situations where parent contributes parent stock to sub and sub uses the P stock to make an acquisition, in the following way: "The transaction is treated as if, immediately before the acquiring entity disposes of the stock of the issuing corporation, the acquiring entity purchased the issuing corporation's stock from the issuing corporation for fair market value with cash contributed to the acquiring entity by the issuing corporation" Arguably implicit in this approach is that form is respected when parent contributes cash to sub and sub immediately uses the cash to buy parent stock. By analogy, arguably form should be respected when P pays off its note to Sub and Sub dividends the proceeds to P.

(47) H.R. Rep. No. 108-755, at 315.

(48) See Notice 2005-38, [section] 7.02, which reads: "the amount of indebtedness of a CFC to any related person pursuant to section 965(b)(3) is not reduced or otherwise offset by indebtedness of any related person to the CFC. Thus, for example, if on the initial measurement date or the last measurement date, there is $ 100x of indebtedness of a CFC to its U.S. shareholder, and $ 10x of indebtedness from such U.S. shareholder to the CFC, the amount of indebtedness under section 965(b)(3)(A) as of such date is $ 100x (and not $ 90x)."

(49) Tax Technical Corrections Act of 2005, H.R. 3376 and S. 1447 (introduced July 21, 2005).

(50) Joint Committee on Taxation, Description of the Tax Technical Corrections Act of 2005 (July 21, 2005), JCX-55-05 (emphasis added).

(51) Treas. Reg. [section]1.702-1(a)(8)(ii) provides that "Each partner must also take into account separately the partner's distributive share of any partnership item which, if separately taken into account by any partner, would result in an income tax liability for that partner, or for any other person, different from that which would result if that partner did not take the item into account separately."

(52) I.R.C. [section] 965(c)(1).

(53) The exception applies to the following obligations: (1) section 956(c)(2)(A)(i)--deposits with any bank (as defined by section 2(c) of the Bank Holding Company Act of 1956 (12 U.S.C. [section] 1841(c)), without regard to subparagraphs (C) and (G) of paragraph (2) of such section); (2) section 956(c)(2)(J)--deposits of cash or securities made or received on commercial terms in the ordinary course of a United States or foreign person's business as a dealer in securities or in commodities, but only to the extent such deposits are made or received as collateral or margin for (i) a securities loan, notional principal contract, options contract, forward contract, or futures contract, or (ii) any other financial transaction in which the Secretary determines that it is customary to post collateral or margin; (3) section 956(c)(2)(K)--an obligation of a United States person to the extent the principal amount of the obligation does not exceed the fair market value of readily marketable securities sold or purchased pursuant to a sale and repurchase agreement or otherwise posted or received as collateral for the obligation in the ordinary course of its business by a United States or foreign person which is a dealer in securities or commodities; (and 4) section 956(c)(2)(L)--securities acquired and held by a controlled foreign corporation in the ordinary course of its business as a dealer in securities if (i) the dealer accounts for the securities as securities held primarily for sale to customers in the ordinary course of business, and (ii) the dealer disposes of the securities (or such securities mature while held by the dealer) within a period consistent with the holding of securities for sale to customers in the ordinary course of business.

(54) This is the case without regard to the second sentence and without regard to whether the CFC is engaged in a U.S. trade or business.

(55) Notice 2005-64, [section] 10.07. This rule expands the exception for trade payables provided in Notice 2005-38, [section] 7.02.

(56) The following example is provided:

USP wholly owns CFC1 and CFC2. USP properly adopts a domestic reinvestment plan that provides for the reinvestment of up to $10 million of qualifying dividends in the United States. During the election year CFC1 pays qualifying dividends of $8 million, CFC2 pays qualifying dividends of $2 million, USP invests at least $10 million in permitted investments, and all the other requirements of section 965 are met. Unless the plan provides only for the reinvestment of qualifying dividends from either CFC 1 or CFC2, the entire $10 million of qualifying dividends is subject to section 965.

(57) That section provides that funding an obligation to fund a qualified plan pursuant to a domestic reinvestment plan ordinarily will be a permitted investment.

PHILIP A. STOFFREGEN is a principal in the International Corporate Tax Practice of KPMG LLP's Detroit, Michigan, office. Mr. Stoffregen received his B.A. degree from Earlham College and both his J.D. and Ph.D. degrees from the University of Chicago. He formerly clerked for the U.S. Tax Court and is a frequent speaker and writer on international tax subjects. This article complements articles on the Treasury Department and Internal Revenue Service's guidance under section 965 of the Internal Revenue Code, which were published in the January-February 2005 issue of The Tax Executive (by the author and Steven R. Lainoff and Elizabeth Satkoski) and the May-June 2005 issue (by the author and Ms. Satkoski). Mr. Stoffregen thanks Caren Shein, Natan Leyva, and Elizabeth Satkoski for their contributions to this article.