By Anthony Diosdi
Before enactment of the 2017 Tax Cuts and Jobs Act (“TCJA”), the Internal Revenue Service (“IRS”) Form 5471 was a reasonable exercise. Prior to the enactment of the TCJA, the IRS Form 5471 was approximately two pages long. This all changed with the enactment of the TCJA. The days of preparing two page long Form 5471s are long gone. The IRS Form 5471 along with its accompanying Schedule J has become one of the most difficult tax returns to complete. This is the result of the complexity and incompleteness of the TCJA’s international tax provisions, along with congressional failure to remedy the gaps that TCJA created in the Internal Revenue Code. Thus, the Department of Treasury (“Treasury”) and the IRS are left to bridge the gaps in the Internal Revenue Code created by the TCJA and promulgate extraordinarily complicated regulations. As a result, the IRS grossly expanded Form 5471 and accompanying Schedule J in a way that could not have been imagined just a few years ago.
The IRS’s Proposed Regulations Governing Section 959 Basketing and Ordering Rules for PTEP Distributions
Where the E&P of a controlled foreign corporation (“CFC”) consists in whole or in part of previously tax earning and profits (“PTEP”), special rules under Section 959 apply in determining the ordering and taxation of distributions of such PTEP. Amounts included in the gross income of a U.S. shareholder as GILTI or subpart F income are not included in gross income again when such amounts are distributed to the shareholder, directly, indirectly, or through a chain or ownership. A PTEP distribution is generally allocated in the following order: 1) PTEP attributable to investments in U.S. property under Section 959(c)(1); 2) PTEP attributable to subpart F income under Section 959(c)(2); and (3) general current and accumulated E&P under Section 959(c)(3). For Section 959 purposes, a distribution is generally attributable to E&P according to the “last in first out” method (“LIFO”).
On November 28, 2018, the Department of Treasury and the IRS released proposed regulations related to the determination of the foreign tax credit (the Proposed Regulations). Under the Proposed Regulations, CFCs are required to establish an annual account for PTEP for each of the Section 904 baskets. Within each account, a CFC is required to assign a PTEP to one of ten different PTEP groups in each of the relevant Section 904 basket based on the U.S. shareholder’s underlying income inclusion, while also taking into account PTEP reclassifications as a result of a Section 956 inclusion.
Under the proposed regulations, PTEP taxes are as follows: 1) foreign taxes deemed paid by the CFC under Internal Revenue Code Section 960(a) for a current year income inclusion in a PTEP group; 2) the foreign income taxes paid or accrued by a CFC as a result of a Section 959(b) distribution that was allocated and apportioned to a PTEP group; and 3) for a reclassified PTEP group of foreign income taxes that were paid, accrued, or deemed paid for an amount that was initially included in a Section 959(c)(2) PTEP group which was reclassified as a Section 959(c)(1) PTEP group. PTEP group taxes are reduced by the amount of foreign taxes in that particular group paid by the U.S. shareholder under Section 960(b)(1) or by another CFC under Section 960(b)(2) that have been reclassified to a Section 959(c)(1) PTEP.
Under the proposed regulations, a CFC’s current year taxes are associated with a PTEP group for Section 960(b) purposes only if the receipt of Section 959(b) distribution causes an increase in a PTEP group. The increased PTEP group is treated as an income group to which current-year taxes are imposed solely by reason of the Section 959(b) distribution. Taxes that are allocated and apportioned to a PTEP group by reason of a CFC’s receipt of Section 959 distribution are allocated and apportioned to the PTEP group under Treasury Regulation Regulation 1.904-6 principles.
Section 960- Deemed Paid Credits on Distributions of PTEP
For any distributions of PTEP, the ordering rule determines the type of PTEP that is distributed. Such determination is particularly important for purposes of determining the creditability of any foreign taxes that are imposed by the CFC’s country on the PTEO distributions.
Prior to the enactment of the TCJA, former Internal Revenue Code Sections 902 and 960(a)(1) permitted a corporate U.S. CFC shareholder to claim a credit for foreign taxes paid by a CFC when the related income was either distributed to the shareholder as a dividend or included in the shareholder’s income as a subpart F inclusion. This would result in the amount of paid foreign taxes based on multi-year “pools” of E&P, with the shareholder generally deemed to have paid the same proportion of the CFC’s post-1986 foreign income taxes as the amount of the dividend or subpart F inclusion as it related to the CFC’s post-1986 undistributed earnings.
TCJA repealed Section 902 and modified Internal Revenue Code Sections 904 and 960. TCJA eliminated the multi-year pooling system and introduced a “properly attributable standard” for the purposes of crediting foreign taxes. Under Section 960(a) and (b), a corporate U.S. shareholder can claim a deemed paid credit for foreign income taxes that are properly attributable to current subpart F and GILTI inclusions. In addition, under Section 960(b), a CFC shareholder is deemed to have paid foreign income taxes that are properly attributable to distributions of PTEP received from a first-tier CFC or from a lower-tier CFC.
Treasury and the IRS determined that adherence to Treasury Regulation 1.904-6 created the need to track and account for several new groups of PTEP because Section 959(c)(2) PTEP (and related deemed paid foreign tax credits) may arise by reason of income inclusions under Sections 951(a)(1)(A), 245A(e)(2), Section 951A(f)(1), 959(E), 964(e)(4), and 965(a), or by reason of the application of Section 965(b)(4)(A). Also, because Section 959(c)(c)(2) PTEP may be reclassified as Section 959(c)(1) PTEP as a result of Sections 956 and 959(a)(2), PTEP groups for Section 959(c)(1) PTEP must be maintained. Finally, PTEP subaccounts must be maintained for each Section 904 foreign tax credit category. See Curtail U.S. PTEP Reporting Complexity: Know Your P’s and Q’s, by Lewis J. Greenwald, Brainard L. Patton, and Brendan Sinnott, Volume 172, Number 5, August 2, 2021.
IRS Notice 2019-01
Notice 2019-01 announced Treasury and IRS’s intention to withdraw prior proposed regulations under Internal Revenue Code Section 959 and issue new proposed regulations under Internal Revenue Code Sections 959 and 961.The proposed regulations discussed in Notice 2019-01 included rules related to the maintenance of PTEPs in annual accounts, in specific groups, and the ordering of PTEPs when distributed or reclassified. Notice 2019-01 added an additional six PTEP groups to the ten PTEP groups described in the proposed regulations. Thus, within each basket, PTEP is allocated up to sixteen groups to be determined on an annual basis.
Notice 2019-01 describes regulations that the Treasury intended to propose that involve PTEP ordering upon distribution. Generally, and subject to a special priority rule for PTEP arising from Section 965(a) and (b), the notice applies a LIFO approach to the sourcing of distributions from annual PTEP accounts. Thus, subject to the special priority rule, Section 959(c)(1) PTEP in the most recent annual PTEP account is treated as distributed first, followed by the second most recent PTEP account, and continued through each annual PTEP account under Section 959(c)(1) until each account is exhausted. The same approach will then apply to Section 959(c)(2) PTEP. Finally, the remaining amount of any distributions are sourced from Section 959(c)(3), to the extent thereof.
The Final Section 960(b) Regulations
On December 17, 2019, the Treasury and the IRS issued final regulations under Internal Revenue Code Section 960(b) which finalized the proposed regulations. The final Section 960(b) regulations modified the proposed regulations. The PTEP groups have consolidated the 959(c)(2) PTEP groups into five. The five PTEP groups arise under Internal Revenue Code Sections 965(a), 965(b)(4)(A), 951A(f)(2), 245A(d), and 951(a)(1)(A). Section 959(c) requires U.S. shareholders to reclassify Section 959(c)(2) PTEP as Section 959(c)(1) PTEP whenever the CFC has a Section 956 investment in U.S. property that was included in the U.S. shareholder’s gross income under Section 951(a)(1)(A) or would have been included except for Section 959(a)(2). In that case, the Section 959(c)(2) PTEP group is reduced by the functional currency amount of the reclassified PTEP, which is added to the corresponding Section 959(c)(1) PTEP group described in the Section 904 category and same annual PTEP account as the reduced Section 959(c)(2) PTEP group.
The post TCJA Form 5471 Schedule J serves the same purposes as its pre TCJA predecessor. However, the post TCJA version greatly expanded E&P tracking requirements. The post TCJA Form 5471 Schedule J increased the 959(c)(2) PTEP categories to be disclosed on the schedule from one to five. It also expanded 959(c)(1) PTEP categories from one to five. In addition, Schedule J requires untaxed E&P to be allocated into E&P subject to the Section 909 anti-splitter rules, E&P carried over from certain nonrecognition transitions, and hovering deficits under Section 959(c)(3). In addition, the Treasury Regulations under Section 1.960-3 requires that CFC shareholders report PTEP attributions attributable to Section 965 inclusions, 965(b) deficit offsets, Section 956 investments in U.S. property, GILTI inclusions, subpart F inclusions, Section 245A hybrid dividends, and Section 1248 amounts. Within these categories, CFC shareholders must state whether or not the PTEP should be allocated to a Section 959(c)(2) or Section 959(c)(1) PTEP. CFC shareholders must separately track each PTEP according to its foreign tax credit category. In addition, CFC shareholders must track movements of PTEPs between Setions 959(c)(2) and Section 959(c)(1) categories.
The rules governing distributions from a CFC pose a significant challenge. If you are a shareholder of a CFC, you should consult with an international tax attorney or qualified tax professional to advise you of your compliance requirements and to provide you with valuable tax planning advice.
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 San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi tax practice encopasses counseling both corporate and private clients. He represents multinational corporations on cross-border planning, tax controversy, and tax compliance throughout the United States. 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.