On August 26, 2026, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) published proposed regulations under Code Sections 951 and 951A clarifying the determination of a U.S. shareholder’s pro rata share of a controlled foreign corporation’s (CFC) Subpart F income and net CFC tested income (NCTI). The proposed regulations, which generally apply to taxable years beginning after December 31, 2025, implement statutory amendments from the One Big Beautiful Bill Act (OBBBA) affecting income inclusion due to mid-year changes in CFC ownership. The proposed regulations introduce significant structural considerations that will impact M&A transactions involving CFCs.
Prior Law: The “Hot Potato” Rule
Under pre-OBBBA Section 951, a U.S. shareholder of a CFC was required to include in gross income its pro rata share of the CFC’s Subpart F income (generally easily moveable, passive-type income) only if the U.S. shareholder owned CFC stock on the last day of the CFC’s taxable year (the so-called “hot potato rule”). The U.S. shareholder’s pro rata share was previously calculated based on a hypothetical year-end distribution model, which incorporated specific statutory adjustments to account for mid-year stock acquisitions and dividend payments. Similarly, pre-OBBBA Section 951A relied on historical allocation and timing principles to determine a U.S. shareholder’s pro rata share of a CFC’s tested income and tested loss under the former global intangible low-taxed income (GILTI) regime.
For purposes of the CFC rules:
- A U.S. shareholder is any U.S. person that owns, within the meaning of Section 958(a) or (b), a 10% or greater interest, by vote or value, in a foreign corporation; however, CFC inclusions apply only to U.S. shareholders that own stock of a CFC directly or indirectly under Section 958(a) (“Section 958(a) shareholders”).
- A CFC is a foreign corporation that is more than 50% owned by U.S. shareholders.
The hot potato rule yielded a planning strategy that allowed a U.S. shareholder to avoid Subpart F or GILTI inclusions by disposing of its CFC stock before the last day of the CFC’s taxable year. Instead, a U.S. shareholder acquiring the CFC stock would bear the full burden of inclusions for its share of the CFC’s full-year Subpart F and GILTI, even if the acquirer held the stock for only a single day.
The OBBBA eliminated the hot potato rule, instead adopting a more equitable system to allocate CFC income among U.S. shareholders based on the duration of actual ownership. Under current law, a Section 958(a) shareholder that owns stock of a foreign corporation on any day during a year that the corporation is a CFC is subject to Subpart F and NCTI inclusions. To promote compliance, the OBBBA granted Treasury broad authority to issue regulations under these new statutory rules.
Highlights of the Proposed Regulations
Default allocation method: The daily proration approach
The most significant highlight of the proposed regulations is a daily proration approach to calculate a Section 958(a) shareholder’s pro rata share of a CFC’s Subpart F income and NCTI. Under the proposed regulations, a Section 958(a) shareholder’s pro rata share is determined by two factors: (1) the percentage of the CFC stock owned by the Section 958(a) shareholder; and (2) the percentage of the CFC’s taxable year the Section 958(a) shareholder owned the stock.
The significance of the daily proration framework comes into play when there are mid-year ownership transfers. In those cases, a selling or buying Section 958(a) shareholder’s pro rata share is based on the proportion of the year it held the stock. Each block of CFC shares that are owned for the same continuous period during the CFC’s taxable year are subject to a separate calculation to account for shares acquired and sold at different points during the year and their respective holding periods. Notably, the proposed regulations do not provide an exception for extraordinary items (such as a large gain recognized by the CFC on the last day of its taxable year).
Mandatory closing of CFC taxable year for CFC status changes
The proposed regulations provide for a mandatory closing of a foreign corporation’s taxable year when a foreign corporation either becomes or ceases to be a CFC (referred to as a “status change event”). The foreign corporation’s taxable year closes at the end of the day the status change event occurs, and the closing applies for all purposes of the Code and all shareholders of the foreign corporation, not just those shareholders involved in the transaction giving rise to the status change event. The proposed regulations would apply an aggregate approach to domestic partnerships (including certain S corporations) and disregard options to acquire stock so that CFC status is tested by reference to Section 958(a) shareholders actually subject to any inclusions under Section 951 or 951A.
Elective closing of CFC taxable year
In addition to the mandatory closing rule, the proposed regulations permit the “controlling Section 958(a) shareholders” to elect to close a CFC’s taxable year if a “significant ownership variance” occurs. If the election is made, the closing of the CFC’s tax year applies for all purposes of the Code and for all shareholders at the end of the day the significant ownership variance happens; moreover, all U.S. shareholders that own stock of the CFC on or before the date of the significant ownership variance must enter a binding written agreement to apply the election.
A significant ownership variance occurs when one or more specified transfers occurring pursuant to the same plan result in a decrease of more than 50 percentage points in Section 958(a) shareholder ownership of the CFC. The controlling Section 958(a) shareholders are all Section 958(a) shareholders whose ownership decreases in a significant ownership variance. A specified transfer includes a sale, exchange, or other disposition of stock of a foreign corporation or partnership interest, as well as an issuance of stock or a partnership interest. If multiple specified transfers occur on different dates pursuant to the same plan, the significant ownership variance is treated as occurring on the day of the last transfer.
A related-party exception provides that a U.S. shareholder’s ownership is not treated as decreasing if a related U.S. person increases its ownership in the CFC. This prevents elective closings from being triggered by related-party transfers that do not involve meaningful change in economic ownership or similar compliance burdens as occurs among unrelated parties.
Applicability
The preamble to the proposed regulations states that Treasury and the IRS expect to finalize the proposed regulations by January 4, 2027. In the meantime, though, taxpayers may rely on the proposed regulations if the taxpayer and related parties apply the rules consistently and in their entirety. Treasury and the IRS have requested comments on the proposed regulations by October 26, 2026.
Practical Implications
Under the proposed regulations, both domestic sellers and buyers of CFC stock will share in the CFC’s Subpart F income and NCTI for the year of the transaction in proportion to their holding periods. These new rules fundamentally change deal economics and will require parties to pay close attention in transaction documents, including covenants addressing tax information-sharing obligations, allocation of risk of extraordinary items (without any regulatory exception, for example, a large gain recognized by the CFC near the deal closing would be allocated between the parties based on daily proration, regardless of when the gain economically arose), and potential elective tax year closing provisions.
Importantly, the proposed regulations do not address the sale of domestic corporations that own CFCs (such as a domestic corporation purchasing 100% of another domestic corporation that has wholly owned CFCs) and therefore, these transactions likely still require further consideration of the allocation of liabilities for Subpart F income and NCTI in the transaction documents.
Examples
Example 1: Direct sale of CFC stock mid-year
Scenario A: Without an elective tax year closing
Seller (a Section 958(a) shareholder) sells 100% of its stock in a wholly owned CFC to an unrelated Buyer (also a Section 958(a) shareholder) on day 182 of the CFC’s calendar tax year. Because the parties do not elect to close the CFC’s tax year, the income allocation is based strictly on the Seller’s and Buyer’s holding periods of the CFC stock. Seller is allocated a pro rata share of the CFC’s total annual Subpart F income and NCTI for the 182 days it held the stock, while Buyer is allocated the share corresponding to the remaining 183 days.
Scenario B: With an elective tax year closing
Same facts as Scenario A, but the parties elect to close the CFC’s tax year. The parties can elect to close the CFC’s tax year because the transaction qualifies as a significant ownership variance (i.e., the sale caused a greater than 50 percentage point decrease in Section 958(a) shareholder ownership). As a result, the CFC’s tax year closes at the end of day 182, splitting the CFC’s calendar year into two short tax years. Instead of a daily pro rata split, income is allocated based on when it was generated. Seller includes the CFC’s Subpart F income and NCTI generated during the first short year (days 1 to 182), and Buyer includes the Subpart F income and NCTI generated during the second short year (days 183 to 365).
Scenario C: With a mandatory tax year closing
Seller (a Section 958(a) shareholder) sells 100% of its stock in a wholly owned CFC to Buyer (a nonresident alien individual) on day 182 of the CFC’s calendar tax year. Because Buyer is not a Section 958(a) shareholder, the transaction triggers a status change event (i.e., the CFC ceases to be a CFC upon the sale). This drop in status forces a mandatory closing of the CFC’s taxable year at the end of day 182, splitting the calendar year into two short tax years. For the first short year (days 1 to 182), the entity operates as a CFC and Seller must include all Subpart F income and NCTI generated during this initial 182-day period. For the second short year (days 183 to 365), because the entity is no longer a CFC during this post-closing period, it cannot generate Subpart F income or NCTI.
Example 2: Indirect sale of CFC stock mid-year
Seller (a Section 958(a) shareholder) owns a 40% interest in a U.S. partnership, which wholly owns a CFC. Under the look-through rules, the partners of the partnership are treated as directly owning the CFC stock for Sections 951 and 951A purposes. On day 182 of the CFC’s calendar tax year, Seller sells all of its 40% interest in the partnership to an unrelated Buyer (also a Section 958(a) shareholder), while the partnership continues to exist. Because only a 40% indirect interest in the CFC is sold, the transaction fails to meet the greater than 50 percentage point threshold required for a significant ownership variance. Consequently, the parties cannot elect to close the CFC’s tax year, and the income must be allocated using the default daily pro rata method. Seller receives a pro rata share of the CFC’s entire annual Subpart F income and NCTI, calculated based on its 40% indirect ownership multiplied by the 182 days it held the interest. Buyer receives the remaining pro rata share of the CFC’s entire annual Subpart F income and NCTI, calculated based on its acquired 40% indirect ownership multiplied by the remaining 183 days.
Example 3: Consolidated group indirect purchase of CFC stock mid-year
Seller owns 100% of a U.S. C corporation (a Section 958(a) shareholder), which in turn wholly owns a CFC. On day 182 of the CFC’s calendar tax year, Seller sells all of its C corporation stock to Buyer (a member of a U.S. consolidated corporate group). The C corporation joins the consolidated group on the following day. Notably, the C corporation’s ownership of the CFC remains unchanged (a significant ownership variance has not occurred), and the entity remains a CFC throughout the entire taxable year (a status change event has not occurred). Under Sections 951 and 951A, the Subpart F income and NCTI inclusions are taken into account in the C corporation’s taxable year that includes the last day it owns the CFC stock. Because the CFC’s taxable year ends when the C corporation is a member of the Buyer consolidated group, the entire full-year inclusion amount is reported on the consolidated group’s tax return. As a result, Buyer effectively bears the U.S. tax on the CFC income generated during the 182 days the Seller owned the C corporation. Unless there are changes to the proposed regulations that address this fact pattern, parties to similar transactions will need to proactively manage this closing-date mismatch.
If you have any questions, or would like additional information, please contact one of the attorneys on our Federal & International Tax team.
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