In 2017, Congress enacted The Tax Cuts and Jobs Act (“TCJA”) adding section 965 to the Internal Revenue Code. Section 965 imposed a one-time transition tax on certain earnings accumulated in foreign corporations. While the statute contained many operational rules, it left many open questions, especially the adjustment of the taxpayer’s basis in stock of a foreign corporation with respect to which the taxpayer had an inclusion under section 965.
The final section 965 regulations (the “Final Regulations”), published in the Federal Register on February 5, 2019, provide further guidance on many issues including the treatment of basis. Specifically, the Final Regulations specify that taxpayers wishing to make or revoke a previously-made basis adjustment election must do so by May 6, 2019, if their tax returns were otherwise due by May 6, 2019. For all other taxpayers, the basis adjustment election must be made with taxpayer’s first return that includes a section 965(a) inclusion amount and cannot be revoked. In addition, the Final Regulations provide that section 9100 relief is not available to file a late election.
In addition to current and future cash tax implications, taxpayers should also carefully consider the effect of the basis adjustment election on their deferred tax provisions. Adjustments to CFC stock basis from making this election or amending a previously-made election may affect the amount of deferred tax liability taxpayers are required to recognize on their investment in a foreign subsidiary for ASC 740 purposes.
Taxpayers who make this election could reduce or eliminate tax upon a distribution of income previously taxed under section 965, and in addition may have significant financial statement impacts. Consequently, taxpayers should immediately consider whether making a basis adjustment election would provide beneficial results.
Previously taxed earnings and profits and stock basis adjustments
To avoid double taxation of amounts included in a U.S. shareholder’s income under section 965, section 959 provides rules to prevent previously taxed earnings and profits (“PTEP”) -- generally earnings of a controlled foreign corporation (“CFC”) that is or has been included in the taxable income of a U.S. shareholder under Subpart F -- from being subject to U.S. tax again when distributed to such U.S. shareholder. Distributions made by a CFC are considered to come first from PTEP to the extent thereof.
Section 961 provides rules for adjusting the basis of shares in a CFC that correspond with the PTEP rules under section 959. It is intended to ensure that the U.S. shareholder who was previously taxed on the earnings of a CFC is not taxed again (in the form of gain attributable to PTEP) if it sells its interest in the CFC (or in a foreign entity through which the CFC is owned) prior to receiving a distribution of the PTEP. Under these rules, taxpayers must increase their basis in stock of a CFC to account for Subpart F income inclusions, and decrease it to reflect distributions of PTEP. If a PTEP distribution from a CFC exceeds the U.S. shareholder's CFC stock basis, the U.S. shareholder recognizes gain.
Interaction with the section 965 one-time transition tax
Section 965(a) requires U.S. shareholders to include in income an amount (the section 965(a) inclusion amount) based on the accumulated post-1986 deferred foreign earnings of specified foreign corporations (“SFCs”) (i.e., CFCs and any other foreign corporation that has a 10 percent corporate U.S. shareholder) as if those earnings had been repatriated to the U.S. As a result, any deferred foreign earnings subject to tax becomes PTEP (“section 965(a) PTEP”) under section 959; the U.S. shareholder's basis in the SFC stock is increased under section 961(a); and a distribution of section 965(a) PTEP results in a stock basis decrease under section 961(b).
Section 965(b) allows U.S. shareholders to reduce the section 965(a) inclusion amount based on deficits in earnings and profits (“E&P”) accumulated by other SFCs. Under section 965(b)(4)(A), the deferred foreign earnings that would have been included in a U.S. shareholder’s income under section 965(a), but were not so included because of the sharing of an E&P deficit pursuant to section 965(b), increases PTEP for the SFC that had positive earnings. Section 965(b)(4)(B), in turn, increases the E&P of a E&P deficit foreign corporation by the amount of the E&P deficit taken into account under section 965(b).
The following example illustrates these rules: USP, a domestic corporation, owns all of the stock of foreign corporations CFC1 and CFC2. USP, CFC1, and CFC2 are calendar-year taxpayers. On all measurement dates, CFC 1 has accumulated post-1986 deferred foreign earnings of $100, and CFC2 has an E&P deficit of $20. USP in aggregate will have an $80 section 965(a) inclusion amount ($100 from CFC1 less CFC2’s $20 deficit allocated to CFC1 under section 965(b)). CFC1’s PTEP account will increase by $100 ($80 for the section 965(a) inclusion amount and $20 for the section 965(b) deficit allocated to CFC1). CFC2 will have $0 of PTEP, and its E&P will increase by the $20 of deficit taken into account under section 965(b).
The issue of missing basis
In general, the statute failed to provide specific rules to adjust the basis of CFC stock to account for a reduction to a U.S. shareholder’s section 965(a) inclusion from allocation of a section 965(b) deficit, even though PTEP is created for such amounts as described above. As a result, SFCs may not be able to distribute PTEP arising from section 965(b) deficits without recognizing gain.
Returning to the example, assume that USP has a basis of $0 in its CFC1 stock and $10 in its CFC2 stock. USP’s stock basis in CFC1 will be increased by only $80 ($100 earnings less $20 deficit), notwithstanding having a PTEP account of $100 ($80 of section 965(a) PTEP and $20 of section $965(b) PTEP). In addition, CFC2 would retain its $10 stock basis notwithstanding the allocation of deficits to CFC1. If CFC1 were to distribute $100 to USP, USP would recognize $20 of capital gain ($100 distribution less $80 of basis). Same result if USP were to sell its shares in CFC1 for $100 to an unrelated buyer.
The basis adjustment election
To address the issue, the proposed section 965 regulations (the “Proposed Regulations”) provided that a U.S. shareholder may elect to increase the tax basis in an SFC with positive deferred foreign earnings (referred to as a “deferred foreign income corporation” or “DFIC”) provided a corresponding reduction of the tax basis of the E&P deficit foreign corporation (“EDFC”) is also made. However, if the amount of the E&P deficit allocated from the EDFC to the DFIC under section 965(b) exceeds the amount of the stock basis in the EDFC allocated to the DFIC under the basis adjustment election, then the U.S. shareholder would be required to recognize immediate capital gain equal to the excess. Stated differently, under the Proposed Regulations, the EDFC must have sufficient stock basis to transfer to the DFIC to cover the entire deficit, otherwise the shortfall is a capital gain to the U.S. shareholder.
If the basis adjustment election were made in the above example, USP’s basis in CFC1 would increase by an additional $20 for a total increase of $100 (matching CFC1’s 965 PTEP account). USP’s basis in CFC2 would be reduced by $20. However, because USP has a basis of only $10 in its CFC2 stock, the election would result in immediate capital gain recognition of $10. USP, of course, would recognize no further capital gain when it receives a distribution of $100 from CFC1.
The Final Regulations modify the “all or nothing” aspect of the basis adjustment election by allowing U.S. shareholders to limit the amount of the basis adjustment, both upward and downward, thus permitting the U.S. shareholder to avoid gain. In the example above, USP could elect to transfer only $10 of basis from CFC2 to CFC1, leaving CFC2 with basis of $0 and deferring the $10 of capital gain until CFC1 distributes earnings in excess of $90. The Final Regulations also allow an individual U.S. shareholder who made a section 962 election to adjust the basis of his or her SFCs under the basis adjustment election.
Absent an affirmative election by the U.S. shareholder, however, no basis adjustments will be allowed. To make the election, the U.S. shareholder will need to attach a statement, signed under penalties of perjury, to its return. The statement must include the U.S. shareholder’s name, taxpayer identification number, and a statement that the U.S. shareholder and all related persons make the election.
The basis adjustment election was introduced Aug. 1, 2018, the date the Proposed Regulations were released. In addition, the Proposed Regulations provided that this election generally must be made on a timely filed return (including extensions). This left many U.S. shareholders with a short window to examine the impact of making the election. The extension of time provided for in the Final Regulations to make or amend a previously-made election is welcome relief and provides U.S. shareholders with additional time to undertake this difficult analysis within both the tax planning and tax provision framework.