Tax

On November 29, 2024, the Treasury Department (“Treasury”) and the Internal Revenue Service (“IRS”) announced proposed regulations (the “Proposed Regulations”) (REG-105479-18) regarding previously taxed earnings and profits (“PTEP”) of foreign corporations and related basis adjustments. The IRS requests public comments on the proposed rulemaking, which aims to clarify the tax consequences of PTEP under Sections 959 and 961 of the United States Internal Revenue Code of 1986, as amended (the “Code”)¹.

Background.

Earnings and profits (“E&P”) of a controlled foreign corporation (“CFC”) are generally included in the gross income of U.S. shareholders; however, certain rules exclude E&P from U.S. tax when distributed as a dividend. Section 959 excludes from a U.S. shareholder’s gross income actual and deemed distributions that are considered Subpart F income, which is PTEP. Section 961 provides rules on basis increases to reflect an income inclusion under Section 951, and basis reductions and gain recognition to reflect PTEP distributions. Together, Sections 959 and 961 are meant to prevent the double-taxation of PTEP for U.S. shareholders of foreign corporations. 

The current rules pertaining to Sections 959 and 961 have not been updated in nearly 60 years. The Tax Cuts and Jobs Act of 2017 (“TCJA”) expanded PTEP by enacting provisions like the transition tax under Section 965 and the participation exemption under Section 245A, which created new categories of CFC E&P that must be properly tracked to correctly allocate foreign taxes. In response to the TCJA changes, and to provide guidance on PTEP accounting, the IRS issued Notice 2019-1, 2019-3 IRB 275 (“2019 Notice”), announcing its intent to issue updated regulations pertaining to Sections 959 and 961 and to withdraw 2006 proposed regulations. Recognizing the 2006 proposed regulations were never finalized, the IRS removed them in 2022. The new Proposed Regulations address longstanding issues under Sections 959, 961, and related Code provisions to prevent double taxation of PTEP. Specifically, the rules provide guidance on PTEP accounting, exclusions and adjustments, and basis. Although not a creation of TCJA, when compared with other international tax provisions, PTEP has taken on increased importance since the TCJA was enacted.

PTEP Accounting, Exclusions from Gross Income, and Related Determinations and Adjustments.

The Proposed Regulations under Section 959 provide rules for PTEP accounting, exclusions from gross income, and related determinations and adjustments. The Proposed Regulations require a covered shareholder (which is defined as a U.S. person other than a partnership) that owns stock in a foreign corporation to “establish and maintain annual PTEP accounts, dollar basis pools, and PTEP tax pools with respect to the foreign corporation.” The annual PTEP accounts track the foreign corporation’s PTEP with respect to the covered shareholder; the dollar basis pools track the basis in U.S. dollars of the previously taxed earnings and profits; and the PTEP tax pools track the U.S. dollar amount of any foreign income taxes associated with the previously taxed earnings and profits.

Weil Tax Observation: The Proposed Regulations to the PTEP accounting regime impose additional compliance complexities and administrative burdens at both the shareholder and entity level. The IRS acknowledges the added complexities and welcomes public comments on other approaches that may decrease the burden of maintaining PTEP accounts and tracking basis adjustments and distributions, while improving overall accuracy.

Treasury and the IRS note the annual PTEP accounts, dollar basis pools, and PTEP tax pools provide proper tracking of excluded income amounts and are therefore integral to the PTEP system. Additional guidance in the Proposed Regulations addresses rules regarding PTEP accounting at the shareholder and foreign corporation level, adjustments to shareholder-level accounts, distributions of PTEP to a covered shareholder or CFC excluded from gross income, allocation of PTEP to certain income amounts, and general successor transactions that transfer a foreign corporation’s PTEP.

The PTEP accounting rules under the Proposed Regulations, replace the current regulations describing a CFC’s PTEP, and the Proposed Regulations regarding the apportionment and allocation of certain year taxes to PTEP replaces current rules for the purposes of applying Section 960(b). The Proposed Regulations under Section 960 maintain the computation of taxes deemed paid, with limitations to a CFC’s PTEP arising by reason of a PTEP realization event during its taxable year as gross income in a residual income group, rather than as gross income in a PTEP group. However, the Proposed Regulations operate in accordance with the proposed PTEP accounting rules under Section 959 that provide specific rules for allocating and apportioning current year taxes arising from a PTEP realization event and require tracking the foreign income taxes associated with PTEP.

PTEP Distributions.

The Proposed Regulations provide rules regarding (1) whether there was a distribution of PTEP under Section 959 and (2) whether the distribution is subject to the exclusions from gross income under Section 959(a)(1) and (b) for PTEP that is distributed to a covered shareholder or a CFC.  

Covered Distributions.

In order to determine whether there was a distribution of PTEP that would be excluded under Section 959, the Proposed Regulations require that the distribution be a “covered distribution”, which is generally defined as any distribution made by a foreign corporation with respect to its stock to the extent that the distribution is a dividend (as defined in Section 316), determined without regard to Section 959(d).

Notably, while a covered distribution may include deemed distributions treated as dividends (for example, distributions under Section 304), the preamble makes clear that a covered distribution does not include an amount treated as a dividend by reason of Sections 78, 367(b), 964(e)(1), or 1248. Treasury and the IRS note that deemed dividends under Sections 367(b), 964(e) and 1248, regardless of whether they constitute deemed distributions of E&P, are determined by excluding PTEP (apart from Treasury Regulations Section 1.367(b)-2(j)(2)(ii), which separately provides for a deemed distribution of PTEP in certain nonrecognition transactions, and Treasury Regulations Section 1.367(b)-3(g)(1), which separately provides for a deemed distribution of E&P, including PTEP, in certain inbound nonrecognition transactions described in Treasury Regulations Section  1.367(b)-3). The Proposed Regulations do not address the treatment of dividends arising under Section 356(a)(2) as covered distributions, which they note will be addressed in future guidance regarding reorganizations.

Weil Tax Observation: The Proposed Regulations also provide some areas of certainty, including with respect to distributions of taxable Section 962 E&P from a CFC to another CFC being covered by Section 959(b). The Proposed Regulations also notably add a helpful timing rule that helps avoid an issue that might have arisen when a CFC realized subpart F income early in the year but made a distribution before year-end.

Exclusions from Gross Income.

Under the Section 959(a)(1) exclusion, PTEP distributed to a covered shareholder, other than taxable Section 962 PTEP, is excluded from the covered shareholder’s gross income. Under the Section 959(b) exclusion, PTEP distributed by a CFC to another CFC is excluded from the recipient CFC’s gross income for purposes of determining the recipient CFC’s subpart F income and tested income or tested loss, provided that the PTEP relates to a covered shareholder that is a U.S. shareholder in both CFCs. Applying the Section 959(b) exclusion for purposes of determining the recipient CFC’s tested income or tested loss prevents double taxation (and thus is consistent with the policy of Section 959) in cases where the distribution is not a related party dividend described in section 951A(c)(2)(A)(i)(IV) and therefore could otherwise result in tested income. Treasury and the IRS note that applying the Section 959(b) exclusion only to PTEP distributed by a CFC to another CFC is consistent with the statute.

Weil Tax Observation: Helpfully, the Proposed Regulations ensure that the Section 959(b) exclusion applies to such PTEP when received by a CFC. Treasury and the IRS are studying the application of Section 959(b) to other PTEP distributed by a foreign corporation that is not a CFC (for example, in a case where the foreign corporation was a CFC when the PTEP was generated but is no longer a CFC when the PTEP is distributed). Irrespective of whether the Section 959(b) exclusion applies to PTEP distributed to a foreign corporation, the Proposed Regulations clarify that PTEP remains PTEP and, in a subsequent distribution, may be excluded from gross income under Section 959(a)(1) or (b). However, the Proposed Regulations have a special rule under which a specified foreign corporation that is not a CFC is treated as a CFC when applying the exclusion to Section 965 PTEP, which Treasury and the IRS note is required to give effect to Section 959(a), which does not depend on the CFC status of any intermediary entities through which a covered shareholder ultimately receives PTEP.

Under the composition rules related to distributions, PTEP is sourced from Section 959(c)(1) groups before section 959(c)(2) groups and sourced on a ‘last in first out’ basis, subject to a priority rule for Section 965, and PTEP of the same priority is sourced pro rata. The Section 965 priority rule is intended to simplify recordkeeping and administration, according to the preamble.

Weil Tax Observation: Requiring Section 965 PTEP to be distributed first may reduce recordkeeping but can result in adverse foreign tax credit consequences to taxpayers in the short term. 

Proposed Regulations Under Section 961 Providing for Basis Adjustments Related to PTEP.

Section 961 authorizes regulations that provide for basis increases to reflect income inclusions under Section 951 and basis reductions and gain recognition to reflect distributions of PTEP. Generally, the purpose of basis increases is to prevent PTEP of a foreign corporation from giving rise to additional U.S. tax in a sale or exchange of stock of the foreign corporation or property through which such stock is owned (for example, an interest in a partnership) when the stock or other property is sold before the PTEP is distributed. The purpose of basis reductions and gain recognition is to prevent double benefits from the basis increases provided under Section 961.

Thus, the Proposed Regulations under Section 961 adjust the basis in shares of stock of a foreign corporation owned by a covered shareholder, and the basis in any items of property through which the covered shareholder owns stock of the foreign corporation, to reflect the foreign corporation’s PTEP with respect to the covered shareholder (for example, to reflect income inclusions giving rise to the PTEP or distributions of the PTEP). Unlike annual PTEP accounts, basis adjustments under the Proposed Regulations are specific to a share of stock or other item of property, consistent with each item of property having separate basis under the Code. Further, the Proposed Regulations under Section 961 provide rules for different types of basis under Section 961, including the tax consequences of the basis.

Under the Proposed Regulations, the type of basis provided in an item of property depends on whether the direct owner of the item is a covered shareholder, partnership, or CFC. This is because when the direct owner of an item of property is a partnership or CFC, covered shareholder-specific basis is necessary so that the benefits of basis provided in the item to reflect income inclusions of a covered shareholder inure only to that shareholder. Additionally, Section 961(c) provides that the basis in the case of an item of property directly owned by a CFC only applies for the purposes of determining the amount included under Section 951 in the gross income of a U.S. shareholder.

Three specific types of property units are outlined in the Proposed Regulations for the purposes of applying basis adjustments under Section 961: (1) Section 961(a) ownership units and adjusted basis provided to a covered shareholder, (2) derivative ownership units and derived basis provided to a partnership and is covered shareholder-specific, and (3) Section 961(c) ownership units and Section 961(c) basis provided to a CFC and is covered shareholder-specific. The Proposed Regulations also provide rules to establish the basis of each type of property unit, which states basis must be maintained in U.S. dollars.

Hypothetical and Actual Distribution Rule.

Under the Proposed Regulations, under a hypothetical distribution rule, the basis of a property unit is increased by an amount that would be distributed in a hypothetical distribution by the CFC equal to the dollar amount of the covered shareholder’s income inclusions. This distribution is treated as being made through all tiers on the last relevant day of the CFC’s tax year. In this way, a property unit is generally provided an amount of basis matching the amount by which basis of the property unit is reasonably expected to be reduced under Section 961 when PTEP resulting from the income inclusions is subsequently distributed to the covered shareholder.

The rules also provide for an actual distribution rule, which applies if the CFC distributes PTEP before the last day of a tax year to better match basis with distributions. The actual distribution rule applies chronologically to distributions of a CFC’s PTEP, and basis increases to CFC stock cannot exceed the covered shareholder’s income inclusions under the rule, excluding Section 951(a)(1)(B) inclusions. The actual distribution rule applies only to distributions on CFC stock the shareholder owns on the last relevant day. Basis increases under the rule “tier up” through property units through which the covered shareholder owns the stock. Under the hypothetical distribution rule and actual distribution rule, basis increases are treated as made at the beginning of the CFC’s tax year or at the beginning of the tax year the covered shareholder owns the property unit.

Additional rules apply for midyear transactions, with a basis increase under the hypothetical or actual distribution rule treated as made at the earliest time during the CFC’s tax year at which the same ownership structure is in place as the ownership structure when the distribution is made.

Section 961(c).

The Proposed Regulations also provide rules for reducing basis and recognizing gain to reflect PTEP distributions. Gain treatment differs depending on the property unit type. At times, the rules diverge from the 2006 proposed regulations, including adjustments to Section 961(a) ownership units and basis attributable to Section 961 not shifting from one share to another when PTEP is distributed. The Proposed Regulations also make it clear that Section 961(c) adjustments apply to tested income and tested loss.

Under the Proposed Regulations, in a sale, exchange, or other disposition by a CFC of one or more Section 961(c) ownership units that are shares of stock of a single foreign corporation (transferred units), the CFC first determines gain recognized with respect to the transferred units (covered gain). Covered gain is determined on an aggregate basis with respect to all transferred units, without regard to Section 961(c) basis or loss recognized on any transferred unit (and before any application of Section 964(e) or other dividend recharacterization provisions). While Treasury and the IRS note that aggregating positive Section 961(c) basis is intended to replicate the effect of netting gains and losses on similar types of property in determining a CFC’s subpart F income, the Proposed Regulations do not allow positive Section 961(c) basis of transferred units in excess of the covered shareholder’s share of the covered gain to be applied to other covered gain or to create a loss that reduces subpart F income or tested income.

Weil Tax Observation: According to Treasury and the IRS, allowing Section 961(c) basis in stock of a foreign corporation to only reduce a Section 951 inclusion attributable to sales, exchanges, or other dispositions of stock of that foreign corporation is consistent with the language of Section 961(c), with the result that only shares of stock of the same foreign corporation should be viewed as similar types of property for purposes of replicating the effect of netting under Section 961(c). However, the allowance of aggregation of Section 961(c) adjustments only with respect to a specific foreign corporation, but the disallowance of aggregation of Section 961(c) loss against gain between corporations, appears to create some distortions. For instance, in the case of “normal basis”, if a selling CFC has gain on the sale of a CFC and loss on the sale of another CFC, those would offset, which would not be the case in respect of Section 961(c) basis.

The Proposed Regulations also make clear that a CFC’s Section 961(c) basis with respect to a covered shareholder in stock of a lower-tier foreign corporation that is provided under the Proposed Regulations when that lower-tier foreign corporation was a CFC continues to exist, however, if that lower-tier foreign corporation ceases to be a CFC (i.e., a share of stock of the lower-tier foreign corporation is a Section 961(c) ownership unit regardless of CFC status).

Weil Tax Observation: Thus, for example, Section 961(c) basis in stock of a foreign corporation that was a CFC but ceases to be a CFC may transfer to another covered shareholder in a general successor transaction and become Section 961(c) basis with respect to that covered shareholder. Notably, the Proposed Regulations do not include guidance relating to whether basis under Section 961 should be increased to reflect gain treated as a dividend under Section 1248(c)(2) or 964(e)(1) (for example, to the extent gain recognized by a covered shareholder on a sale of stock of a first-tier CFC is treated as a dividend under Section 1248(c)(2) by reason of E&P of a third-tier CFC (and therefore gives rise to PTEP under Section 959(e))). Thus, future Treasury and IRS guidance is still needed relating to whether (and to what extent) the first-tier CFC’s and second-tier CFC’s Section 961(c) basis can and should be increased to reflect the resulting PTEP.

Proposed Regulations Under Section 986 Related to Foreign Currency Gain or Loss.

Foreign currency gain or loss is recognized under Section 986(c) when PTEP is distributed to a covered shareholder, or when PTEP ceases to be with respect to the covered shareholder. Additional guidance under the Proposed Regulations describes circumstances where a covered shareholder recognizes foreign currency gain or loss because of varying exchange rates between the time there is an income inclusion giving rise to PTEP, and the date of the transaction requiring gain or loss recognition. The amount of foreign currency gain or loss recognized is determined by converting the PTEP denominated in the foreign corporation’s functional currency into U.S. dollars at the spot rate on the date of the transaction and subtracting from that dollar amount the applicable dollar basis of the PTEP. Notably, foreign currency gain or loss is not recognized with respect to PTEP distributions made to a foreign corporation.

Certain Miscellaneous Provisions, Partnership Rules and Anti-avoidance rules.

Successor Transactions. The Proposed Regulations provide guidance relating to successor transactions. Generally, PTEP is transferred to a covered shareholder that acquires stock ownership in a foreign corporation. These successor rules generally ensure that PTEP is not subject to U.S. tax again in the hands of the acquiring covered shareholder when received in a distribution, even though that shareholder did not own the stock of the foreign corporation when the PTEP was generated and therefore did not have the inclusion that gave rise to the PTEP. Additionally, the rules ensure that E&P retains its PTEP status and thus remains subject to the rules under Sections 959 and 961, rather than reverting to Section 959(c)(3) E&P and potentially becoming eligible for a deduction under Section 245A without a reduction in basis.

Partnerships and Anti-avoidance.The Proposed Regulations also address a multitude of other issues, such as rules pertaining to Section 958. Before TCJA, domestic partnerships were treated as owning stock of a foreign corporation, and PTEP accounts were maintained at the partnership level as well as adjustments to basis. This changed in 2019 with rules that treated a domestic partnership as an aggregate of the partners when applying Section 951A, which was later extended to Section 951.

Weil Tax Observation: Considering that the rules for partnerships and partners are a combination of aggregate treatment in some places and entity treatment in others, there could be significant difficulty in application. For instance, if the partnership has many assets, there could be complexity in complying with both the Proposed Regulations, while also following through rules generally applicable to domestic partnerships under subchapter K.

The Proposed Regulations also outline anti-avoidance rules under Section 959 and 961, with adjustments made if a transaction is made with the principal purpose of avoiding the rules.

Weil Tax Observation: The anti-avoidance rules under the Proposed Regulations are similar to those issued under the proposed dual consolidated loss and disregarded payment regulations. It is possible that we continue to see similar anti-avoidance rules in forthcoming regulations, as it appears Treasury is using such broad rules more frequently now as a backstop to attack transactions. The result is uncertainty in the scope of the anti-avoidance rules.

Open Questions. Notably, the Proposed Regulations do not address any guidance relating to certain nonrecognition transactions, redemptions, transactions to which Section 964(e) applies, and structures where CFCs are partners (Notice 2024-16 announced intent to issue proposed regulations addressing basis treatment under Section 961(c) for transactions involving the acquisition of CFC stock by a domestic corporation in a Section 332 liquidation or Section 368(a)(1) asset reorganization).

Furthermore, future regulations should clarify whether expenses besides foreign income taxes, such as interest expense, should go against PTEP and whether certain PTEP rules should apply only to entities that are currently CFCs.

Applicability Date and Transition Rules.

Generally, the Proposed Regulations apply to taxable years of foreign corporations beginning on or after the date the Proposed Regulations are finalized and published in the Federal Register. However, certain provisions of the Proposed Regulations under Section 959 applying to U.S. Shareholders and foreign corporations are subject to the interim application of the 2019 Notice provisions. Subject to satisfying certain requirements, taxpayers have the option to apply the Proposed Regulations to taxable years of foreign corporations beginning before the general applicability date. If elected, taxpayers must apply the Proposed Regulations as finalized for all succeeding years.

The Proposed Regulations also include transition rules under Section 959 to facilitate the establishment and conformity of PTEP accounts as of the beginning of the first taxable year to which the Section 959 regulations apply. Transition rules are also considered under Section 961 for establishing derived basis and Section 961(c) basis.