What Is the Section 245A Dividends Received Deduction?

The Section 245A deduction was introduced as part of the Tax Cuts and Jobs Act of 2017, marking a shift in how the U.S. taxes foreign earnings of domestic corporations. This provision is a component of the move toward a territorial tax system, which taxes income based on where it is earned. Section 245A allows a U.S. C-corporation to deduct 100% of the dividends it receives from certain foreign subsidiary corporations. The purpose of this deduction is to permit U.S. companies to repatriate foreign earnings without an additional layer of U.S. tax, encouraging the reinvestment of foreign profits back into the United States.

Core Requirements for the Deduction

To benefit from the Section 245A deduction, the entity receiving the dividend must be a domestic C-corporation. Individuals, S-corporations, partnerships, real estate investment trusts (REITs), and regulated investment companies (RICs) are not eligible to claim this deduction. The rule is structured to apply to corporate shareholders within a multinational structure.

The corporation paying the dividend must be a “specified 10-percent owned foreign corporation” (SFC). An SFC is any foreign corporation where a domestic C-corporation is a “United States shareholder,” a status achieved by owning at least 10% of the foreign corporation’s stock by either vote or value.

A notable exception to the SFC definition involves passive foreign investment companies, or PFICs. A foreign corporation classified as a PFIC with respect to the shareholder does not qualify as an SFC for this deduction. This exclusion is important because PFIC rules are designed to prevent U.S. taxpayers from deferring tax on passive investments held through foreign corporations. Dividends from a PFIC that is not also a controlled foreign corporation (CFC) are not eligible.

Finally, the deduction applies only to the “foreign-source portion” of the dividend. The eligible amount is calculated based on the foreign corporation’s underlying earnings. The foreign-source portion is determined by a ratio of the SFC’s undistributed foreign earnings to its total undistributed earnings, connecting the tax benefit to profits from foreign operations.

Disqualifying Rules and Major Limitations

Even if the core requirements are met, several rules can limit or disallow the Section 245A deduction. One is a mandatory holding period for the stock of the foreign corporation. To qualify, the domestic corporation must have held the stock for more than 365 days during the 731-day period that begins 365 days before the ex-dividend date. This rule prevents corporations from making short-term purchases of foreign stock simply to receive a tax-free dividend.

The holding period calculation includes specific safeguards. Under Section 246, the clock stops on any day where the shareholder has diminished its risk of loss in the foreign stock. This can occur if the shareholder enters into financial positions, such as an option to sell or a short sale. The purpose of this provision is to ensure the domestic corporation bears the economic risks of ownership for the required period.

Another limitation applies to “hybrid dividends,” which are payments treated differently for tax purposes in the U.S. and the foreign country. The Section 245A deduction is disallowed if the payment is a dividend under U.S. law, but the foreign corporation that paid it was able to claim a deduction or other tax benefit for the payment in its home country. This rule prevents a “double non-taxation” scenario.

If a U.S. shareholder receives a hybrid dividend, it is not permitted to claim the Section 245A deduction. The rules also extend to controlled foreign corporations (CFCs) that receive hybrid dividends from other CFCs. In such cases, the hybrid dividend is treated as Subpart F income to the receiving CFC, causing the ultimate U.S. shareholder to have a current income inclusion.

A set of anti-abuse rules targets dividends connected to “extraordinary dispositions.” An extraordinary disposition is the sale of assets by a CFC that is outside its normal course of business, with the proceeds then paid out as a dividend. These rules prevent corporations from generating earnings through one-time asset sales, such as a factory or intangible property, and then repatriating the cash tax-free.

Calculating the Deduction and Impact on Foreign Tax Credits

Once a dividend is confirmed to be eligible, the specific amount that can be deducted must be calculated. The deduction is equal to the “foreign-source portion” of the dividend. This portion is determined by a pro-rata calculation where the numerator is the “undistributed foreign earnings” of the SFC and the denominator is the SFC’s total “undistributed earnings.” This resulting fraction is then multiplied by the dividend amount.

The term “undistributed earnings” refers to the earnings and profits of the foreign corporation as of the close of its taxable year, without being reduced for dividends distributed during that year. The “undistributed foreign earnings” are the portion of those earnings not attributable to certain types of U.S.-connected income. This requires meticulously tracking the earnings and profits accounts of foreign subsidiaries.

A significant consequence of claiming the Section 245A deduction is the disallowance of any associated foreign tax credits or deductions. A taxpayer cannot claim a foreign tax credit (FTC) or a deduction for any foreign income taxes, including withholding taxes, paid on a dividend for which the 100% DRD is taken. This rule prevents a double tax benefit.

This trade-off requires careful analysis by corporate taxpayers. A corporation must weigh the benefit of the 100% deduction against the value of the foreign tax credits it would be forfeiting. In situations where the foreign tax rate is high, the value of the FTCs could be substantial. The decision involves modeling the tax outcomes of either claiming the deduction and losing the credits or forgoing the deduction to utilize the credits.

Compliance and Reporting Obligations

Properly claiming the Section 245A deduction requires diligent record-keeping and specific reporting on corporate income tax returns. A domestic corporation must maintain documentation to substantiate its eligibility. This includes records verifying its ownership percentage, proof that the holding period requirement was met, and detailed calculations of the dividend’s foreign-source portion.

The primary form for reporting the deduction is Form 1120, the U.S. Corporation Income Tax Return. The Section 245A deduction is specifically reported on Schedule C, “Dividends and Special Deductions.” On this schedule, a corporation lists the dividends received from the specified 10-percent owned foreign corporations and claims the corresponding 100% deduction for the eligible portion.

In addition to Form 1120, U.S. shareholders of foreign corporations must file detailed information returns. The most relevant form is Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” This form requires extensive reporting on the foreign corporation’s financial activities, including its balance sheet, income statement, and transactions with the U.S. shareholder.

Failure to comply with these reporting obligations can lead to significant penalties. The IRS requires this detailed transparency to verify that the deduction is being claimed correctly and that all associated rules, such as the disallowance of foreign tax credits, are being followed.