What Was the Section 956A Excess Passive Assets Rule?

Section 956A was a provision within the U.S. Internal Revenue Code that addressed earnings of foreign corporations invested in “excess passive assets.” Enacted in 1993, the rule limited the ability of U.S. taxpayers to indefinitely defer American income tax on certain offshore income. It accomplished this by treating a portion of a foreign corporation’s retained earnings as if they had been distributed to its U.S. owners, subjecting that income to immediate taxation. Congress repealed Section 956A in the Small Business Job Protection Act of 1996, effective for tax years of foreign corporations beginning after December 31, 1996.

The Purpose and Target of the Provision

The objective of Section 956A was to discourage the stockpiling of passive income in foreign corporations to avoid U.S. taxation. The law targeted a business structure known as a Controlled Foreign Corporation (CFC), a foreign-based company where over 50% of its stock is owned by U.S. Shareholders. A U.S. Shareholder was defined as a U.S. person or entity owning 10% or more of the foreign corporation’s voting stock.

Under U.S. international tax law, income earned by a foreign subsidiary is not subject to U.S. tax until paid as a dividend to its American parent company, a principle known as deferral. Section 956A was created to counteract the abuse of this privilege. The concern was that a CFC could accumulate passive investment income, like interest and dividends, without repatriating it, thereby deferring U.S. tax. The provision accelerated this tax liability when a CFC held excessive assets unrelated to its active business.

Calculating the Taxable Amount

The calculation for Section 956A involved identifying and measuring “excess passive assets.” A passive asset was defined as an item not used in an active trade or business, such as stocks, bonds, commodities, non-business real estate, and annuities. The rule established a quantitative threshold to determine if a CFC’s holdings of these assets were excessive.

The calculation compared a CFC’s total passive assets to 25% of its total assets, measured on a quarterly average. Any amount of passive assets exceeding this 25% threshold was deemed “excess passive assets” and treated as a dividend paid to the CFC’s U.S. Shareholders. Consequently, U.S. Shareholders had to include their share of this amount in their gross income for the tax year, even though they received no actual cash distribution from the foreign corporation.

Repeal and Current Law Context

Congress repealed Section 956A in 1996, only three years after its enactment, due to its complexity and the administrative burden it placed on taxpayers. Lawmakers found the rule created unintended incentives, such as encouraging CFCs to acquire active foreign assets they otherwise would not have purchased simply to alter their asset ratios. The provision was also seen as overlapping with other existing anti-deferral regimes.

While Section 956A is no longer law, its goal of preventing indefinite tax deferral on passive income persists in the Internal Revenue Code. The rules governing this area, known as Subpart F, remain a feature of U.S. international taxation. A related provision, Section 956, also continues to be in effect and treats a CFC’s investment in certain U.S. property, such as loans to its U.S. parent, as a deemed dividend.