SECTION 2. BACKGROUND

.01 Section 965 — In General

The American Jobs Creation Act of 2004 (P.L. No. 108–357) (the Act), enacted on October 22, 2004, added new section 965 to the Code. In general, and subject to limitations discussed below, section 965(a) provides that a corporation that is a U.S. shareholder of a controlled foreign corporation (CFC) may elect, for one taxable year, an 85 percent DRD with respect to certain cash dividends it receives from its CFCs.

Section 951(b) defines the term “U.S. shareholder” with respect to any foreign corporation as a U.S. person who owns (within the meaning of section 958(a)), or is considered to own (under the construc

tive ownership rules of section 958(b)), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation. Section 965(c)(5)(A) provides that all U.S. shareholders that are members of an affiliated group filing a consolidated return under section 1501 are treated as one U.S. shareholder. For purposes of this notice, the term “U.S. shareholder” means, unless otherwise indicated, a domestic corporation that, at any time after the beginning of the base period (defined below), is a U.S. shareholder (as defined in section 951(b)) with respect to a CFC and that owns (within the meaning of section 958(a)) stock of such CFC. For purposes of section 965, the term “dividends” includes cash amounts included in gross income as dividends under sections 302 and 304, but does not include amounts treated as dividends under section 78 or 1248 or, in certain cases, section 367. ¹ H.R. Conf. Rep. No. 108–755, at 314–15 (2004). Also for this purpose, a cash dividend includes a cash distribution from a CFC that is excluded from gross income under section 959(a) (regarding distributions of previously taxed income (PTI)) to the extent of inclusions under section 951(a)(1)(A) as a result of a cash dividend during the election year to: (1) such CFC from another CFC in a section 958(a) chain of ownership; or (2) any other CFC in such chain of ownership from another CFC in such chain of ownership, but only to the extent of cash distributions described in section 959(b) made during such year to the CFC from which such U.S. shareholder received such distribution.

Section 965(b) imposes four limitations on the section 965(a) DRD. These limitations are discussed in detail below in paragraphs .02 through .05 of this section.

Section 965(d) and (e) provide special rules that limit the use of foreign tax credits and the deduction of certain expenses to offset the nondeductible portion of section 965(a) dividends, respectively. See section 9.01 of this notice. These rules will be addressed in greater detail in a subsequent

1 Dividends resulting from liquidations qualifying under section 332 to which section 367(b) applies qualify as cash dividends to the extent the U.S. shareholder actually receives cash as part of the liquidation. Section 965(c)(3). A deemed liquidation effectuated through an election under Treas. Reg. §301.7701–3(c), however, does not by itself result in an actual distribution of cash as required under section 965. See H.R. Conf. Rep. No. 108–755, at 315, n. 108 (2004).

2005–22 I.R.B. 1100 May 31, 2005

such corporations on the basis of their respective interests in the CFCs giving rise to such inclusions immediately after such distribution. Section 965(c)(2)(C)(ii) also provides that this rule does not apply if neither the controlled corporation nor the distributing corporation is a U.S. shareholder of such CFCs immediately after the distribution.

.03 Maximum Amount Eligible for Section 965(a) — Greater of $500 Million or Permanently Reinvested Earnings

Section 965(b)(1) limits the amount of dividends eligible for the section 965(a) DRD to the greatest of the following three amounts: (1) $500 million ($500 million limitation); (2) the amount shown on the taxpayer’s applicable financial statement as earnings permanently reinvested outside the United States; or (3) in the case of an applicable financial statement that does not show a specific amount of earnings permanently reinvested outside the United States but that does show a specific amount of tax liability attributable to such earnings, the amount of such liability divided by 0.35. If the applicable financial statement does not show a specific earnings or tax liability amount, then the $500 million limitation applies. The section 965(b)(1) amount shown on the taxpayer’s applicable financial statement as earnings permanently reinvested outside the United States and the amount shown as a specific amount of tax liability attributable to such earnings divided by 0.35 is referred to in this notice as “APB 23 limitation.”

Under section 965(c)(1), the term “applicable financial statement” means the most recently audited financial statement (including notes and other documents which accompany such statement) which is certified on or before June 30, 2003, as being prepared in accordance with generally accepted accounting principles, and which is used for the purposes of a statement or report to creditors or shareholders or for any other substantial nontax purpose. If the taxpayer is required to file with the Securities and Exchange Commission, the audited financial statement must be so filed on or before June 30,

notice that the Treasury Department and the IRS expect to issue soon.

Section 965(f) provides that taxpayers may elect the application of section 965 for either the taxpayer’s last taxable year which begins before October 22, 2004, or the taxpayer’s first taxable year which begins during the one-year period beginning on October 22, 2004. The election must be made on or before the taxpayer’s due date (including extensions) for filing its Federal income tax return. See Notice 2005–10; see also H.R. Conf. Rep. No. 108–755, at 314, n. 107 (2004). The taxable year for which a taxpayer elects to apply section 965 will be referred to in this notice as the “election year.”

.02 Extraordinary Dividends

Section 965(b)(2) provides that only those cash dividends (within the meaning of section 965(a)) received from CFCs during the U.S. shareholder’s election year that are considered “extraordinary” are eligible for the section 965(a) DRD. Cash dividends received by the U.S. shareholder during the election year are considered extraordinary only to the extent such dividends exceed the annual average for the base period years of the following items reported on the U.S. shareholder’s tax return as filed (including any amended returns that were filed on or before June 30, 2003): (1) dividends received during each base period year by such shareholder from CFCs ² ; (2) amounts includible in such shareholder’s gross income for each base period year under section 951(a)(1)(B) (regarding investments in United States property under section 956) with respect to CFCs; and (3) amounts that would have been included for each base period year but for section 959(a) with respect to CFCs. ³

The term “base period” in this notice means the five most recent taxable years of the U.S. shareholder that end on or before June 30, 2003. The term “base period inclusion” in this notice means any amount described in (1), (2), or (3) of the preceding paragraph, for any of the U.S. shareholder’s taxable years in the base period. Under section 965(c)(2)(A), the term “base period years” generally in

cludes only three taxable years in the U.S. shareholder’s base period, determined by disregarding the years in the base period for which the base period inclusions are the highest and the lowest. However, if the taxpayer has fewer than five taxable years ending on or before June 30, 2003, then all taxable years ending on or before that date are considered base period years. The average of the U.S. shareholder’s base period inclusions for its base period years is referred to in this notice as the “base period amount.”

Section 965(c)(2)(C)(i) sets forth a general rule applicable to companies entering and exiting corporate groups, which provides that for purposes of determining the base period inclusions (and ultimately the base period amount), rules similar to the rules of section 41(f)(3)(A) and (B) apply. Section 41 generally provides for an incremental credit for qualified research activities, but only to the extent that current year research expenditures exceed the base amount for that year. For purposes of section 41, the base amount is computed by multiplying a measure of the taxpayer’s qualified research expenses during a specified historical period by its average annual gross receipts for the four years immediately preceding the credit year. Section 41(f)(3)(A) and (B) generally provide that, as a result of certain acquisitions and dispositions, a taxpayer may increase or decrease the amount of its qualified research expenses and gross receipts to the extent that such amounts are attributable to the acquired or disposed of portion of a trade or business of the taxpayer.

In addition to the general references to section 41(f)(3)(A) and (B), section 965(c)(2)(C)(ii) provides a special rule for distributions during the base period of stock of a U.S. shareholder to which section 355 (or so much of section 356 that relates to section 355) applies. Under this special rule, the U.S. shareholder, the stock of which is distributed, is treated as having been in existence for the same period that the distributing corporation has been in existence. Further, the base period inclusions of the distributing and controlled corporations prior to the distribution are, in general, allocated between

2 For this purpose, both cash and non-cash dividends received are taken into account. See section 965(b)(2)(B)(i).

3 For this purpose, distributions of PTI for any base period year do not include distributions excluded from gross income by reason of an amount described in section 965(b)(2)(B)(ii) (relating to investments in United States property) with respect to a prior taxable year.

May 31, 2005 1101 2005–22 I.R.B.

base period amount by applying the rules of section 965(b)(2)(B) and (c)(2) with respect to CFCs for which it was a U.S. shareholder at any time during its base period.

(b) Consolidated groups . A consolidated group ⁴ determines its base period inclusions by first aggregating the base period inclusions of each of the members in its group. It then determines its base period amount by determining the average of such inclusions as provided under section 965(b)(2)(B) and (c)(2). (c) Short taxable years . Taxable years of fewer than 12 months are taken into account as taxable years for purposes of determining the base period years pursuant to section 965(c)(2). In addition, base period inclusions in a taxable year of fewer than 12 months are not annualized or otherwise adjusted for purposes of calculating the base period amount.

(d) Intermediary pass-through entities . The Treasury Department and the IRS expect to issue guidance soon on the treatment of distributions to intermediary passthrough entities owned by U.S. shareholders for purposes of section 965(b)(2)(B)(i).

(e) Example . The following example illustrates the application of section 965(b)(2) and this section 3.01. Example . (i) Facts . USP is the common parent of a consolidated group that includes USP’s wholly owned subsidiaries US1 and US2. US1 and US2 each wholly owns a foreign corporation, CFC1 and CFC2, respectively. The USP consolidated group maintains a taxable year ending July 31. US1 received a $100x dividend from CFC1 in each of the consolidated taxable years ending July 31, 1996, 1997, and 1998. US2 received a dividend from CFC2 during each of the consolidated taxable years ending July 31, 1998, 1999, 2000, 2001, 2002, and 2003 in the amount of $150x, $150x, $200x, $100x, $50x, and $100x, respectively.

(ii) Result . USP first determines the base period inclusions of US1 and US2 to determine the consolidated group’s base period inclusions. Pursuant to section 965(c)(2), the base period includes the five most recent taxable years of the USP group that ended on or before June 30, 2003, which are the group’s taxable years ending July 31, 1998 (year 1) through July 31, 2002 (year 5). Accordingly, USP will have base period inclusions as follows:

2003, to qualify as an applicable financial statement. The legislative history states:

[APB 23 limitation] refers to elements of Accounting Principles Board Opinion 23 (“APB 23”), which provides an exception to the general rule of comprehensive recognition of deferred taxes for temporary book-tax differences. The exception is for temporary differences related to undistributed earnings of foreign subsidiaries and foreign corporate joint ventures that meet the indefinite reversal criterion in APB 23. H. R. Conf. Rep. No. 108–755, at 315, n. 111 (2004). The last day covered by the applicable financial statement is referred to in this notice as the “APB 23 determination date.”

Section 965(c)(5) provides special rules for applying section 965 to controlled groups of corporations. First, section 965(c)(5)(B) provides that all corporations treated as a single employer under section 52(a) (section 52(a) group) are limited to one $500 million limitation, and the limitation must be divided among such corporations under regulations prescribed by the Secretary. A section 52(a) group includes all corporations that are members of a controlled group of corporations within the meaning of section 1563(a) substituting, however, “more than 50 percent” for “at least 80 percent” throughout section 1563(a)(1), and making the determination without regard to section 1563(a)(4) and (e)(3)(C). Second, section 965(c)(5)(C) provides that if a financial statement is an applicable financial statement for more than one U.S. shareholder, APB 23 limitation is divided among such shareholders under regulations prescribed by the Secretary.

.04 Increase in Related Party Indebtedness

Section 965(b)(3) provides that the amount of a U.S. shareholder’s dividends otherwise eligible for the deduction under section 965(a) are reduced by any increase in the indebtedness of the CFC to any related person (as defined in section 954(d)(3)) between October 3, 2004, and the close of the taxable year for which the election under section 965 is in effect.

For this purpose, all CFCs with respect to which the taxpayer is a U.S. shareholder are treated as a single CFC and, therefore, indebtedness between CFCs is disregarded for this purpose. See H.R. Conf. Rep. No. 108–755, at 314, n. 109 (2004). Section 965(b)(3) is intended to prevent a deduction from being claimed with respect to a section 965 dividend where the dividend is financed, directly or indirectly, by the U.S. shareholder. In such a case, there may be no net repatriation of funds, and thus it is inappropriate to allow a deduction under section 965(a). H.R. Conf. Rep. No. 108–755, at 315 (2004).

.05 Investment in the United States Pursuant to a Domestic Reinvestment Plan

Section 965(b)(4) requires a U.S. shareholder claiming a section 965(a) DRD with respect to a dividend to invest the amount of the dividend in the United States pursuant to a domestic reinvestment plan. The domestic reinvestment plan must be approved by the taxpayer’s president, chief executive officer, or comparable official before the payment of the dividend and subsequently approved by the taxpayer’s board of directors, management committee, executive committee, or similar body. The domestic reinvestment plan must provide for the investment of the dividend in the United States (other than as a payment for executive compensation), including as a source for the funding of worker hiring and training, infrastructure, research and development, capital investments, or the financial stabilization of the corporation for the purposes of job retention or creation. This list is not intended to be exclusive. H.R. Conf. Rep. No. 108–755, at 316 (2004). For additional guidance with respect to domestic reinvestment plans, see sections 8 and 9 of this notice and Notice 2005–10.