The IRS and the Treasury intend to provide regulations that will address issues affecting foreign corporations with previously taxed earnings and profits (PTEP). The regulations are in response to changes made by the Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97), and are intended to include rules for:
the maintenance of PTEP in annual accounts and within certain groups;
the ordering of PTEP upon distribution and reclassification; and
the adjustment required when an income inclusion exceeds a foreign corporation’s earnings and profits.
The IRS and Treasury intend to withdraw 2006 proposed regulations relating to the exclusion from gross income of PTEP and associated basis adjustments ( NPRM REG-121509-00), and issue new proposed regulations under Code Sec. 959 and Code Sec. 961.
Previously Taxed Earnings and Profits
Previously taxed earnings and profits (PTEP) are a foreign corporation’s earnings and profits attributable to amounts which are or have been included in a U.S. shareholder’s gross income under Code Sec. 951(a) or under Code Sec. 1248(a). Under the subpart F rules, a U.S. shareholder of a controlled foreign corporation (CFC) is generally currently taxed on certain income earned by the CFC, and on certain earnings invested in U.S. property.
To prevent double taxation, Code Sec. 959 provides that earnings and profits of the foreign corporation that are attributable to the inclusion are excluded from gross income when actually distributed. An exclusion is also allowed when earnings and profits are attributable to amounts included in the U.S. shareholder’s gross income that would otherwise again be included in gross income under the rule for investment of earnings in U.S. property.
To determine the amount of an actual distribution that is not taxable because it represents previously taxed income upon an actual distribution by the CFC, the earnings distributed are treated as attributable in the following order:
first, to retained earnings that were required in prior years to be included in income on account of investments in excess passive assets, together with the earnings in prior years that were required to be included in income on account of investments in U.S. property under Code Sec. 956, allocated to each category on a pro rata basis ( “section 959(c)(1) PTEP”);
next, to retained earnings that were required to be included in income as subpart F income ( “section 959(c)(2) PTEP”); and
finally, to other earnings and profits ( “section 959(c)(3) E&P”).
Changes made by the TCJA created the need to account for new groups of PTEP, because section 959(c)(2) PTEP may arise due to income inclusions under Code Secs. 951(a)(1)(A), 245A(e)(2), 951A(f)(1), 959(e), 964(e)(4), or 965(a), or by applying Code Sec. 965(b)(4)(A). Those different groups of PTEP may be subject to different rules under Code Secs. 960, 965(g), 245A(e)(3), and 986(c).
In addition, Proposed Reg. § 1.960-3(c) establishes, for purposes of determining the amount of foreign income taxes deemed paid, a system of accounting for PTEP in annual accounts for each separate category of income ( “section 904 category”) and further segregate each annual account among 10 PTEP groups.
Annual Accounts and Groups of Previously Taxed Earnings and Profits
The new regulations are expected to provide that an annual account must be maintained and each annual PTEP account must be segregated into 16 PTEP groups in each section 904 category:
- reclassified section 965(a) PTEP;
- reclassified section 965(b) PTEP;
- section 951(a)(1)(B) PTEP;
- reclassified section 951A PTEP;
- reclassified section 245A(e)(2) PTEP;
- reclassified section 959(e) PTEP;
- reclassified section 964(e)(4) PTEP;
- reclassified section 951(a)(1)(A) PTEP;
- section 956A PTEP;
- section 965(a) PTEP;
- section 965(b) PTEP;
- section 951A PTEP;
- section 245A(e)(2) PTEP;
- section 959(e) PTEP;
- section 964(e) PTEP; and
- section 951(a)(1)(A) PTEP.
Section 959(c)(1) PTEP will consist of PTEP groups (1) through (9), and section 959(c)(2) PTEP will consist of PTEP groups (10) through (16). Once PTEP is assigned to a PTEP group within an annual PTEP account for the year of the income inclusion under Code Sec. 951(a)(1) or the year of application of Code Sec. 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.
Additionally, the new regulations are expected to provide that:
- 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 earnings and profits in each such 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; and
- distributions from any PTEP group reduce the shareholder’s stock basis under Code Sec. 961(b)(1) without regard to how that basis was originally created.
The regulations also will provide transition rules for annual PTEP accounts maintained before the regulations’ applicability date.
Ordering of Earnings and Profits upon Distribution and Reclassification
The new regulations are expected to provide that:
- a distribution will be a distribution of PTEP only to the extent it would have otherwise been a dividend under Code Sec. 316;
- a “last in, first out” approach will be required for sourcing distributions from annual PTEP accounts, subject to the special priority rule for PTEP arising due to Code Sec. 965;
- PTEP attributable to income inclusions under Code Sec. 965(a) or by reason of Code Sec. 965(b)(4)(A) receive priority when determining the group of PTEP from which a distribution is made; and
- reclassifications of PTEP under Code Sec. 959(a)(2) will be sourced first from section 965(a) PTEP, then section 965(b) PTEP, and then, under a last-in, first-out approach, pro rata from the remaining section 959(c)(2) PTEP groups in each annual PTEP account, starting from the most recent annual PTEP account.
Adjustments Due to an Income Inclusion in Excess of Current Earnings and Profits
The new regulations are expected to provide that:
- current E&P are first classified as section 959(c)(3) E&P, and then section 959(c)(3) E&P are reclassified as section 959(c)(1) PTEP or section 959(c)(2) PTEP, as appropriate, in full, which may result in creating or increasing a deficit in section 959(c)(3) E&P; and
- if a foreign corporation has a current-year deficit in E&P, that deficit will solely reduce the foreign corporation’s section 959(c)(3) E&P without affecting the amount of its section 959(c)(1) PTEP or section 959(c)(2) PTEP.
The new regulations are expected to apply to tax years of U.S. shareholders and successors in interest ending after December 14, 2018, and to tax years of foreign corporations ending with or within the U.S. shareholders’ tax years. Before the regulations are issued, a shareholder can rely on the rules provided in the announcement notice if the shareholder and each related shareholder apply the rules consistently regarding the PTEP of all foreign corporations in which they own stock for all tax years beginning with the shareholder’s or related shareholder’s tax year that includes the tax year end of any such foreign corporation to which Code Sec. 965 applies.