Extraordinary Consequences for Typical Transactions: Final and Proposed Participation Exemption Regulations

The extraordinary disposition rules address the availability of the participation exemption for certain distributions of earnings and profits (E&P) that were not subject to US taxation due to differing effective dates within TCJA.  Specifically:

• The transition tax, which was a one-time tax under section 965 on US shareholders (USSHs) on the deferred earnings of SFCs, measured as of November 2 or December 31, 2017.
• The participation exemption, which is effective for distributions by SFCs made after December 31, 2017.
• The section 951A (GILTI) provisions, which are effective for taxable years of CFCs beginning after December 31, 2017.

Because of these varying effective dates, there was a period of time (the disqualified period, which was between November 3, 2017 or January 1, 2018 and the end of the fiscal year) during which earnings of a non-calendar year CFC were not subject to either section 965 or the GILTI rules, but were nevertheless eligible for the participation exemption if distributed.  In the IRS’s view, this timing mismatch was contrary to the intent of the participation exemption, which was to allow the participation exemption only with respect to SFC earnings that had been taken into account in determining amounts subject to the transition tax or GILTI.

To address this disconformity in effective dates, the extraordinary disposition rules of the 2019 regulations limited the availability of the participation exemption with respect to SFC dividends from E&P attributable to extraordinary asset dispositions. In general, an extraordinary disposition is a non-ordinary course disposition of specified property (generally, any property that produces tested income) to a related party during the disqualified period. Under the 2019 regulations, a transfer of intangible property (IP) was always treated as outside the ordinary course and therefore as an extraordinary disposition.

Final regulations change: Under the final regulations, certain IP transfers will not be considered extraordinary dispositions if the taxpayer had a reasonable expectation that the IP would be sold in the ordinary course of business to a third-party customer within one year. Certain IP that is never transferred in the ordinary course of business (such as trademarks and goodwill) does not qualify for this exception.…

https://www.alvarezandmarsal.com/insights/extraordinary-consequences-typical-transactions-final-and-proposed-participation-exemption