Recently issued proposed IRS regs tie the allocation of a CFC's earnings among multiple classes of stock for tax purposes to FMV differences between the classes if the actual allocation depends on an exercise of discretion by the board of directors (Code section 951(a)(1)). Such amounts include subpart F income and deemed dividends under section 956, which are currently taxable to certain US shareholders without credit for foreign taxes paid by the CFC (except for shareholders that make a certain election or that are C corps holding at least 10 percent of the CFC). If the proposed effective date--a CFC's taxable year beginning after 2004--materializes, taxpayers may have only four months to review and modify their structures if necessary.

The new regs may affect Canadian and other non-US corporations owned by US citizens and residents, including a Canco that was involved in an estate freeze and has fixed-value preferred shares with discretionary dividend rights to the former common shareholders. Last modified in 1965, the regs attempt to reflect intervening business developments and to address some structures that the IRS believes produce inappropriate results. For example, in the "Apache" transaction, Enron formed a CFC that lent money back to it (generating interest deductions). Enron held the common shares and a foreign lender held the preferreds, but under a shareholder agreement no earnings were distributable to Enron while the preferreds were outstanding. Arguably, Enron's common shares produced no subpart F inclusions because they were not subject to a hypothetical year-end distribution; and because distributions were not discretionary, they were arguably outside regulation 1.951-1(e)(3). The new regs provide that restrictions or limitations on the earnings distributions to US shareholders structured by the corporation or its shareholders are generally ignored in determining their pro rata share of subpart F amounts, even if such terms result from an arrangement that is between unrelated parties or that has a non-tax business purpose.

The general rule still applies: allocation to a particular class of stock bears the same ratio to the total section 951(a)(1) amount as the earnings distributable thereto if all earnings were distributed on the last day of the CFC's year (the hypothetical distribution date). But if the allocation between classes depends on board discretion, allocations are based on the relative value of the classes on the hypothetical distribution date, an approach analogous to that used for allocation adjustments under the consolidated-return regs. The right to redeem stock is not a discretionary distribution right under the new rules, a matter that is relevant to a typical Canco CFC freezeco whose preferred shares are redeemable and retractable.

The regs do not specifically address whether they also apply for FPHC purposes. This is potentially important for certain Cancos with US-citizen or US-resident shareholders: many such Cancos are FPHCs, but not CFCs because of the broader FPHC attribution rules, including those rules that may attribute to US shareholders stock held by siblings and by non-US shareholders. (Legislation introduced in the House [HR 4520] on June 4, 2004 proposes to repeal the FPHC rules.)