Determining Taxable Gains from the Sale of CFC Stocks


By Anthony Diosdi
Virtually all controlled foreign corporations (“CFCs”) generate earnings and profits that become previously taxed earnings and profits (“PTEP”). Special rules under Internal Revenue Code Section 959 apply in determining the ordering and taxation of distributions of a PTEP. The rules governing PTEP distributions also apply in determining the basis of CFC corporate stocks. This is because the PTEP regime requires upward and downward basis adjustment in CFC stock for gross income inclusions at the U.S. shareholder level attributable to such CFC. The purpose of the basis adjustments rules of the PTEP regime is to prevent the earnings of a CFC from being taxed at the time of an income inclusion and again when the CFC shareholder sells his or her shares.
When a U.S. shareholder has a subpart F or global intangible low-taxed income (“GILTI”) income inclusion from a CFC, Internal Revenue Code Section 961(a) generally requires a U.S. shareholder to increase its basis in the stock by the total amount of such gross income inclusion or by the amount of the PTEP. On the other hand, Internal Revenue Code Section 961(b) typically requires a U.S. shareholder to reduce his or her basis in the stock in the amount of the PTEP distribution.
Sometimes determining the basis of CFC shares is not clear cut. For example, when a U.S. shareholder makes an election under Section 962 for a taxable year, the basis adjustment rules under the PTEP rules are modified and focus on the amounts of tax paid by the shareholder rather than income inclusion. The PTEP rules may also be modified for the untaxed earnings and profits (“E&P”) of a CFC not taxed under the GILTI rules because it comprises 10 percent QBAI amount identified under Section 951A(b)(2)(A) of the Internal Revenue Code. In such cases, there may be potential differences between the required upward and downward stock basis adjustments.
In situations where the normal upward and downward basis adjustment rules of the PTEP regime do not apply, Internal Revenue Code Section 1248 must be considered. Before the addition of Internal Revenue Code Section 1248, U.S. shareholders of a CFC could “cash in” on and realize the economic benefit of the accumulated earnings of a controlled foreign corporation at long-term capital gains tax rates. The capital gain result could be accomplished by selling stock of the foreign corporation at a price that would reflect the accumulated earnings of the CFC. In either event, the excess of the amount realized upon the sale or liquidation by the U.S. shareholder over the basis in the stock interest disposed of was usually taxed as long-term capital gain. By contrast, if the U.S. shareholder had repatriated the foreign earnings through dividend distributions, the earnings would have been taxed at ordinary rates.
Section 1248 prevents this result by, under specified circumstances, treating the gain recognized on the sale or liquidation of the U.S. shareholder’s stock as a dividend. In the case of corporate sellers, Section 1248(a) treats gain recognized as dividend income to the extent of relevant earnings and profits. However, after the enactment of Section 245A, corporate dividends receive a deduction. Thus, Section 1248 will likely have little if any impact for U.S. corporate shareholders. The situation is different for individual CFC shareholders. If the selling shareholder is an individual and the stock sold is a capital asset held for more than one year in the selling shareholder’s hands, Section 1248(b) limits the tax attributable to the deemed dividend under Section 1248(a) to the sum of two amounts.
The first amount is the selling shareholder’s pro rata share of the U.S. income tax that the CFC would have paid if the CFC had been taxed as a domestic corporation, after permitting a credit for all foreign and U.S. tax actually paid by the CFC on the same income. For example, if a foreign corporation established in the Cayman Islands is classified as a CFC. If the CFC has $100 of income and pays zero foreign taxes, assuming the CFC is taxed at 21 percent, the hypothetical corporate tax would be $21 ($21 – $0 for foreign tax liability = $21). The second amount is the tax that would result by including in gross income as long-term capital gain an amount equal to the excess of the deemed dividend included in the selling shareholder’s income under Section 1248(a), over the first amount. Continuing with the above example and assuming that the CFC shareholder’s gain on the sale is $100, this hypothetical shareholder tax would be 23.8 percent of $79 ($100 Section 1248(a) amount less the hypothetical corporate tax of $21), or $18.80.
Adding together the hypothetical corporate tax and the hypothetical shareholder tax in this example thus results in $39.80 in U.S. tax on the $100 gain, for an effective tax rate of 39.8 percent. Given that the CFC in this example is not a resident in a treaty country (the U.S. does not have a treaty with the Cayman Islands), the amount of gain that is recharacterized as a dividend under Section 1248(a) would be taxed at a maximum federal rate of 40.80 percent. This would result in a federal tax of $40.80 in this example. Because this amount is greater than the Section 1248(b) ceiling of $39.80, the ceiling will apply, and the U.S. shareholder will pay U.S. federal tax of $39.80. See GILTI, Subpart F, FDII Or Flow-Through Structure, That Is The Question: U.S. Tax Considerations For Outbound Business Investment & Activities (2021), Erez I. Tucner and Gennette E. Faust
There are some ways in which U.S. shareholders may be able to avoid Section 1248 dividend treatment. For example, an individual shareholder may be able to avoid Section 1248 by retaining the CFC shares until death. At that point, its tax basis to the legatee is stepped up to its fair market value under Section 1014 without tax on the inherent gain and, accordingly, any gain that could be subject to Section 1248.
Section 338(g) Elections
Sometimes parties involved in the acquisition of CFC shares may contemplate a Section 338(g) election. When a Section 338(g) election is made, the CFC being acquired is treated for tax purposes as if it sold all of its assets and is required to recognize any applicable gain from a deemed asset sale. If the seller of the CFC is a domestic corporation, any CFC gains assigned to non-trade assets are typically treated as subpart F income. Gains assigned to trade or business assets are typically classified as tested income for purposes of GILTI.
With a Section 338(g) election, a domestic seller of CFC shares will have an increase in basis to account for any inclusions under subpart F or GILTI generated as a result of the hypothetical sale of assets. If the seller of the CFC shares is a domestic corporation, any stock gain recharacterized as a dividend under Section 1248 may be exempt from U.S. taxes under Section 245A. If the CFC shareholder is a U.S. individual, Section 245A cannot be utilized to recharacterize a 1248 dividend. Instead, a 1248 dividend will likely be taxed as discussed above. Assuming a Section 962 election is not made, gains not associated with Section 1248 due to a Section 338(g) election will result in a GILTI or subpart F inclusion taxed at ordinary rates. Consequently, a Section 338(g) election is not typically favorable to U.S. individual CFC shareholders.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.

Written By Anthony Diosdi
Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.
