Section 956: What Is an Investment in U.S. Property?

U.S. persons are subject to U.S. income tax on their worldwide income, including earnings from foreign corporations they own. While the U.S. tax system allows for the deferral of tax on a foreign corporation’s active earnings until they are distributed as dividends, this benefit has limits. This deferral allows profits to be reinvested abroad without an immediate U.S. tax.

Internal Revenue Code Section 956 serves as a limitation on this deferral. The provision is designed to prevent U.S. shareholders from accessing the earnings of their foreign corporations tax-free. It accomplishes this by treating certain investments made by a Controlled Foreign Corporation (CFC) in the United States as a “deemed dividend” to its U.S. shareholders. This means that even if no cash is actually paid out, the shareholder may have a tax liability, ending the deferral on that portion of the earnings.

Defining an Investment in U.S. Property

An investment in “U.S. property” by a Controlled Foreign Corporation (CFC) is what triggers the potential tax inclusion for its U.S. shareholders. The definition is broad and encompasses several distinct categories of assets.

A primary category is tangible property physically located in the United States. This includes assets such as real estate, buildings, machinery, and inventory. If a CFC acquires a warehouse in Ohio or a fleet of vehicles for use within the U.S., these assets would be considered U.S. property.

Another category is the stock of a domestic corporation. When a CFC purchases shares in a U.S. company, that stock is treated as U.S. property. This rule prevents a CFC from simply buying an interest in a U.S. affiliate to move cash into the U.S. without it being classified as a dividend.

An obligation of a U.S. person is a frequently encountered category. This includes any debt instrument where a U.S. individual or entity is the borrower. The most direct example is a loan from a CFC to its U.S. parent company, which Section 956 treats as an investment in U.S. property instead of a taxable dividend.

The rule extends beyond direct loans to cover indirect obligations and credit enhancements. If a CFC pledges its assets as security for a loan taken out by its U.S. parent, that pledge is treated as an investment in U.S. property. Similarly, if the CFC guarantees the debt of a U.S. person, the guarantee itself triggers Section 956, as it is viewed as an economic equivalent of a dividend.

However, there are statutory exclusions for what is not considered U.S. property. These include obligations of the United States, such as Treasury bonds, and money held in U.S. bank accounts. Stock or debt of an unrelated domestic corporation is also excluded, provided the CFC’s shareholders do not own a significant interest in it. Additionally, obligations arising from the ordinary course of business, such as trade receivables, are not treated as U.S. property.

The Deemed Dividend Inclusion

When a Controlled Foreign Corporation (CFC) holds an investment in U.S. property, its U.S. shareholders may have a deemed dividend inclusion. The ultimate tax impact of this inclusion differs significantly depending on the type of U.S. shareholder.

For corporate U.S. shareholders, the consequences of a Section 956 inclusion were changed by the Tax Cuts and Jobs Act of 2017. The law introduced a participation exemption system that allows a 100% dividends-received deduction for dividends from foreign subsidiaries. Regulations reduce a corporate shareholder’s Section 956 inclusion to the extent a deduction would have been available if the amount were an actual dividend. As a result, a deemed dividend under Section 956 often no longer results in any additional U.S. tax for corporate shareholders.

In contrast, other types of U.S. shareholders—most notably individuals, Regulated Investment Companies (RICs), and Real Estate Investment Trusts (REITs)—do not benefit from this relief. For these shareholders, the traditional rules continue to apply. A Section 956 inclusion is treated as a taxable deemed dividend, requiring them to include the amount in their gross income for the year as if they had received an actual cash distribution.

Calculating the Inclusion Amount

The calculation of the Section 956 inclusion amount for a U.S. shareholder is determined by a two-part formula. The shareholder must include in their income the lesser of two distinct limitations, tying the inclusion to both the investment amount and available earnings.

The first limitation is the shareholder’s pro-rata share of the average amount of U.S. property held by the Controlled Foreign Corporation (CFC). This is not a year-end snapshot but an average calculated based on the adjusted basis of the U.S. property held by the CFC at the close of each quarter of its taxable year. This quarterly average prevents manipulation where a CFC might dispose of property just before year-end to avoid an inclusion. The adjusted basis of the property is reduced by any liability to which the property is subject.

The second limitation is the shareholder’s pro-rata share of the CFC’s “applicable earnings.” Applicable earnings are the CFC’s current and accumulated earnings and profits (E&P), which are similar to a corporation’s retained earnings. This pool of E&P is reduced by distributions made during the year and by earnings already taxed in the U.S. under other provisions. These previously taxed amounts are known as Previously Taxed Earnings and Profits (PTEP), and excluding them prevents the same earnings from being taxed twice.

Key Exceptions and Exclusions

Even when a Controlled Foreign Corporation (CFC) makes an investment in U.S. property, certain exceptions can prevent a tax inclusion. These provisions act as safe harbors for transactions that are not intended to be tax-avoidant repatriations of foreign earnings.

One exception relates to the acquisition of stock in a U.S. corporation. An exception applies if the CFC and its related persons own less than 25% of the total combined voting power of the domestic corporation. This allows for portfolio-style investments in U.S. companies without triggering a deemed dividend.

Another area of relief involves inadvertent investments. Treasury regulations provide mechanisms to cure transactions that could unintentionally trigger a Section 956 inclusion. For example, if a CFC inadvertently pledges its assets or guarantees a loan for its U.S. parent, there may be a window of time to correct the situation by terminating the pledge or guarantee.

Certain short-term obligations are also excluded from being treated as U.S. property. An obligation of a U.S. person that is collected within one year from the time it is incurred is not considered an investment in U.S. property. This allows for short-term financing arrangements that are part of the normal course of business.

Reporting and Compliance

A U.S. shareholder’s obligation under Section 956 includes mandatory reporting requirements to ensure compliance with the IRS. Failure to properly report a Section 956 amount can lead to penalties and further scrutiny, even if no tax is ultimately due.

The primary tool for reporting is IRS Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” This comprehensive form is used to satisfy the reporting requirements for U.S. persons who have interests in foreign corporations, and a U.S. shareholder of a CFC must file it annually.

Within Form 5471, specific schedules are dedicated to Section 956 amounts. Schedule J, “Accumulated Earnings and Profits (E&P) of Controlled Foreign Corporation,” tracks the CFC’s E&P, including amounts classified as Previously Taxed Earnings and Profits (PTEP). Schedule I, “Summary of Shareholder’s Income From Foreign Corporation,” is where the shareholder summarizes income inclusions from the CFC, including the Section 956 amount.

The final inclusion amount from Form 5471 is carried over to the U.S. shareholder’s main income tax return. For a corporate shareholder, this amount is reported on Form 1120, “U.S. Corporation Income Tax Return.” For an individual shareholder, the inclusion is reported on Form 1040, “U.S. Individual Income Tax Return,” as taxable income.