By Anthony Diosdi
Generally, U.S. shareholders of a controlled foreign corporation or CFC are required to include in the U.S. income: 1) their pro rata share of subpart F income under Internal Revenue Code Section 951(a) (such as passive income, and certain foreign sales and service income); 2) their pro rata share of CFC’s earnings from investments in U.S. property as defined in Internal Revenue Code Section 956; 3) after the enactment of the 2017 Tax Cuts and Jobs Act, other items of global intangible low-taxed income (“GILTI”) as defined in Internal Revenue Code Section 951A. The U.S. shareholder is taxed even if the CFC does not make an actual distribution to the shareholder. To avoid double taxation, Internal Revenue Code Section 959 provides that previously taxed earnings and profits (“FTEP”) of a CFc are not taxed again when distributed to the U.S. shareholder.
Prior to the 2017 Tax Cuts and Jobs Act, a U.S. corporate shareholder could claim a credit for foreign tax deemed paid by the CFC, for any actual or constructive distribution to the shareholders from the CFC. See Former IRC Section 902 and 960. The amount of the deemed foreign tax credit was based on multi-year “pool” of earnings and taxes. After the 2017 Tax cuts and Jobs act, and modified Internal Revenue code Section 960, a U.S. corporate shareholder can claim a deemed paid credit for foreign income taxes attributable to current year subpart F and GILTI inclusions. See IRC Section 960(a) and (b).
Before the enactment of the 2017 Tax Cuts and Jobs Act, under Section 959(a), a distribution by a CFC out of the earnings and profits (“E&P”) that had been previously taxed income was referred to as (“PTI”). Section 959 established ordering rules to keep track of a CFC’s E&P and to prevent double taxation by dividing a CFC’s E&P into three categories, known as:
1. Section 959(c)(1) account, from a prior-year Section 956 inclusions (1) to E&P that were required in prior years to be included as investments in U.S. property);
2. Section 959(c)(2) account, from current or prior year subpart F income inclusions and gains under Section 1248 that would otherwise be treated as capital gain which must be reported as ordinary income;
3. Section 959(c)(3) accounts (other earnings and profits).
Under the 959 ordering rules, an actual distribution was treated as made first out of the Section 959(c)(1) account, then out of the Section 959(c)(2) account, and finally out of the Section 959(c)(3). Within each Section 959(c) account, PTI was considered distributed on a last-in, first-out (“LIFO”) basis.
Below, please see Illustration 1 and Illustration 2 which provide examples regarding the taxation and ordering rules of PTIs.
Illustration 1.
DC, a domestic corporation, owns all the stock of FC, a foreign corporation that a CFC. During year 1, FC has subpart F income of $200, earnings and profits of $400 and pays an actual dividend of $100. Assume that FC pays no foreign taxes on its income. DC must include $200 in gross income as ordinary income under Section 951(a)(1)(A)(i). Under the ordering rules in Section 959(c), DC would exclude the actual dividend of $100 from gross income under Section 959, because the distribution represents earnings and profits attributable to amounts that DC previously included in income under Section 951(a). The actual dividend would reduce FC’s earnings and profits from $400 to $300.
Illustration 2.
USP, a U.S. corporation, owns 100 percent of CFC1, a CFC. CFC1 owns CFC2, another CFC. CFC2 has owned 100 percent of DC, a U.S. corporation, since year 1. CFC2 has an adjusted basis of $3 in its DC stock. CFC2 has E&P of $10 in year 1. During year 2, CFC1 earns subpart F income of $50 to USP on June 1; CFC2 makes a distribution of $6 to CFC1 on December 1.
Year 1.
CFC2’s ownership of shares in DC constitutes an investment in U.S. property under Section 956, giving USP a Section 956 inclusion to the extent of the lesser of 1) CFC2’s E&P or 2) the adjusted basis of CFC2 in DC stock, which is $3 in year 1. This 956 inclusion in year 1 becomes CFC2’s PTI in year 2 as a Section 959(c)(1) PTI.
Year 2.
Typically, under Section 959(f)(2) actual distributions during the year are taken into account before current year Section 956 inclusions. Therefore, $3 of the December 1, year 2, distribution of $6 from CFC2 to CFC1 should be treated as made out of PTI from the year 1 Section 956 inclusion, and the remaining $3 of that distribution should be excepted from subpart F income as per Section 954(c)(6). CFC’1 Section 959(c)(1) PTI account is increased to $3 (the year 1 Section 956 PTI), while CFC2’s Section 959(c)(1) PTI account is reduced to zero before considering the year 2 Section 956 inclusion. See Example in Section 956 and Subpart F Inclusions, Actual Distributions, and Previously Taxed Income, by Hui Yu, June 30, 2014, The Tax Advisor.
Section 959 the Enactment of the 2017 Tax Cuts and Jobs Act
The enactment of the 2017 Tax Cuts and Jobs Act introduced a number of new international tax regimes such as the one-time transition tax under Internal Revenue Code Section 965 and GILTI under Internal Revenue Code Section 951A. Along with these new tax regimes, the IRS in Notice 2019-01 (the “Notice”) announced it will withdraw its current regulations for Section 959 and issue new regulations. Not only will the IRS promulgate new regulations regarding Section 959, the terminology has changed regarding the distributions from a CFC.The terminology has changed regarding the distributions from a CFC. Prior to the issuance of the Notice, Section 959 referred to a distribution by a CFC out of E&P that have been included in the income of a U.S. shareholder as PTI. Going forward, the IRS will refer to previously taxed earnings and profits of a CFC as PTEP instead of PTI. The Notice consists of three parts. Section 3 of the Notice is divided into three subparts. These subparts are referred to as 3.01, 3.02, and 3.03.
Section 3.01 of the Notice states that the new regulations to Section 959 will be enacted to changes made by the 2017 Tax Cuts and Jobs Act and will include rules relating to:
1. The maintenance of PTEP in annual accounts and within certain groups;
2. The ordering of PTEP upon distribution and reclassification; and
3. The adjustments required when an income inclusion exceeds the E&P of a CFC.
The Notice goes on to say that existing PTEP regulations will need to be modified to reflect the additional types of Section 959(c)(2) PTEP created under the 2017 Tax Cuts and Jobs Act. This includes a PTEP for GILTI inclusions, and mandatory transition tax, among others. Each group of PTEP may be subject to different rules under Sections 960, 965(g), 245(e)(3), and 986(c). Furthermore, because Section 959(c)(2) PTEP may be reclassified as Section 959(c)(1) PTEP as a result of a Section 956 investment, similar groups for Section 959(c)(1) PTEP must be maintained in order to properly apply Sections 960, 965(g), 245(e)(3), and 986(c) when earnings are reclassified.
Section 3.01 of the Notice provides that future regulations are expected to provide that an annual PTEP account must be maintained for each CFC and each PTEP account must be segregated into the following 16 PTEP groups in each Section 904 separate limitation category or “basket.”
Section 959(c)(1) PTEP
1. Reclassified Section 965(a) PTEP
2. Reclassified Section 965(b) PTEP
3. Section 951(a)(1)(B) PTEP
4. Reclassified Section 951A PTEP
5. Reclassified Section 245A(e)(2) PTEP
6. Reclassified Section 959(e) PTEP
7. Reclassified Section 964(e)(4) PTEP
8. Reclassified Section 951(a)(1)(A) PTEP
9. Section Section 956A PTEP
Section 959(c)(2) PTEP
10. Section 965(a) PTEP
11. Section 965(b) PTEP
12. Section 951A PTEP
13. Section 245A(e)(2) PTEP
14. Section 959(e) PTEP
15. Section 964(e)(4) PTEP; and
16. Section 951(a)(1)9(A) PTEP
Section 3.01 of the Notice also specifies that future regulations will follow the following:
Once PTEP is assigned to a PTEP group within an annual PTEP account for the year of the income inclusion under Section 951(a)(1), or the year of application of Section 965(b)(4)(A), the PTEP will be maintained in an annual PTEP account with a year that corresponds to the year of the account from which the PTEP originated if PTEP is distributed or reclassified in a subsequent tax year. This means that CFC shareholders must maintain PTEP accounts (in some cases PTEP sub-accounts) for each year and those accounts will have to be maintained until it is exhausted. Section 3.01 of the Notice states that forthcoming regulations will provide the following:
To the extent a CFC has E&P in a PTEP group that is in more than one Section 904 category, any distribution out of that PTEP group is made pro rata out of the E&P in each Section 904 category.
Dollar basis must be tracked for each annual PTEP account, and, to the extent provided in the regulations, separately for each PTEP group within an annual account.
New Ordering of E&P Rules
Section 3.02 of the Notice states that forthcoming regulations will clarify the following:
A distribution will be a distribution of PTEP only to the extent it would have otherwise been a dividend under Section 316. As such, a CFC that does not have current or accumulated E&P would not be able to distribute PTEP, even if it has PTEP accounts.
Under Section 316, distributions are considered first as distributions from current E&P, to the extent thereof, and then as distributions from the most recently accumulated E&P, to the extent thereof. To facilitate the rule in Section 959(c), which incorporates the ordering rule of Section 316, the forthcoming regulations will require a LIFO approach to the sourcing of distributions from annual PTEP accounts, subject to special priority rules applicable the Section 965.
By reason of Section 965(b)(4)(A), Section 965(a) will receive priority when determining the group of PTEP from which a distribution is made. This priority will be integrated into the general ordering rule of Section 959(c)(2) PTEP.
Thus, starting with Section 959(c)(1) PTEP, under the forthcoming regulations, as an exception to the LIFO approach, distributions will be sourced first from reclassified Section 965(a) PTEP and then from reclassified Section 965(b) PTEP. Once those PTEP groups are exhausted, under the LIFO approach, distributions will be sourced pro rata from the remaining Section 959(c)(1) PTEP groups in each annual PTEP account, starting from the most recent annual account. Once the PTEP groups relating to section 959(c)(1) PTEP are exhausted, distributions will be sourced from Section 959(c)(2) PTEP. The forthcoming regulations will provide an exception to the LIFO approach, distributions will be sourced from the Section 965(a) PTEP and then Section 965(b) PTEP. Once those two PTEP groups are exhausted, under the LIFO approach, distributions will be sourced pro rata from the remaining Section 959(c)(2) PTEP groups in each annual PTEP account, starting from the most recent annual PTEP account. Finally, once all the PTEP groups have been exhausted, the remaining amount of any distribution will sourced from Section 959(c)(3) E&P.
Adjustments Due to Income Inclusion in Excess of Current Earnings and Profits
Unlike subpart F inclusions, GILTI inclusions are not limited by current year E&P limitation. In order to provide clarity regarding GILTI inclusions not being limited by E&P limitations. Section 3.03 of the Notice states that the forthcoming regulations under section 959 will provide that current E&P will be first classified as Section 959(c)(3) E&P and then Section 959(c)(3) E&P will be reclassified as Section 959(c)(1) PTEP or Section 959(c)(2) PTEP, as appropriate, in full, which may have the effect of creating or increasing a deficit in Section 959(c)(3). Thus, where a current year GILTI inclusion exceeds available Section 959(c)(3) E&P, that balance becomes negative in order to allow for the creation of the appropriate PTEP while maintaining the current total PTEP.
The rules discussed above are extraordinarily complex. Any U.S. shareholder of a CFC should consult with a qualified international tax professional should they have any questions regarding their U.S. tax compliance requirements.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.