United States

IRS to issue complex rules to account for foreign earnings

Treasury announces complex accounting rules for offshore corporations

TAX ALERT  | 

Notice 2019-01 (the ‘Notice’) announces that the Treasury Department (Treasury) and the Internal Revenue Service (IRS) plan to issue regulations affecting controlled foreign corporations (CFCs) with previously taxed earnings and profits (PTEP). The forthcoming regulations are in response to changes made by the Tax Cuts and Jobs Act (TCJA), 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 adjustment required when an income inclusion exceeds the earnings and profits (E&P) of a CFC.

In 2006, the Treasury and the IRS issued proposed regulations (REG-121509-00), relating to the exclusion from gross income of PTEP and associated basis adjustments (the “2006 proposed regulations”). The 2006 proposed regulations were never finalized. The Treasury and the IRS intend to withdraw the 2006 proposed regulations and to issue new regulations under Internal Revenue Code Sections 959 and 961.

The future regulations are expected to apply to tax years of U.S. shareholders (and successors in interest) ending after Dec. 14, 2018 (the date the Notice was issued) and to tax years of CFCs ending with or within such tax years. Before the issuance of the future regulations, a U.S. shareholder may rely on the rules described in section 3 of the Notice if certain conditions are satisfied.

Comments on the rules described in the Notice are due by Feb. 12, 2019.

Background

Generally, a U.S. shareholder of a CFC is required to include currently in gross income its pro rata share of (i) the CFC’s Subpart F income (which generally includes, among other things, certain passive income and certain sales and services income arising in connection with transactions between the CFC and a related party); (ii) the CFC’s earnings that are invested in U.S. property under Section 956; and (iii) certain other new items under the TCJA, such as global intangible low-taxed income (“GILTI”). Such U.S. shareholders are subject to current U.S. federal income tax with respect to the foregoing income items, even if the CFC has not made an actual distribution to such shareholders.

To avoid double taxation, section 959 provides that such previously taxed earnings and profits (PTEP) are not again taxed when distributed to a U.S. shareholder or any other U.S. person who acquires the U.S. shareholder’s interest (or a portion thereof) in the CFC.

Section 959(c) divides PTEP into three categories and provides that PTEP will be treated as distributed: (i) first, under section 959(c)(1), out of PTEP attributable to section 956 inclusions (“Section 959(c)(1) PTEP”); (ii) second, under section 959(c)(2), out of PTEP attributable to Subpart F income inclusions and section 1248 deemed-dividend inclusions (“Section 959(c)(2) PTEP”); and (iii) third, under section 959(c)(3), to non-previously taxed E&P (“Section 959(c)(3) E&P”).

Annual accounts and PTEP groups

According to the Notice, existing PTEP regulations need to be modified to reflect the additional types of section 959(c)(2) PTEP created under the TCJA, including PTEP for GILTI inclusions, and the mandatory transition tax, among others. Each group of PTEP may be subject to different rules under sections 960, 965(g), 245A(e)(3), and 986(c).

In addition, 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), 245A(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 annual 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 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 provide 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. Thus, taxpayers will need to maintain PTEP accounts (including subaccounts for each subgroup of PTEP) for each year and those accounts will have to be maintained until the accounts are exhausted.Section 3.01 of the Notice also specifies that future 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.
  • Distributions from any PTEP group will reduce the shareholder’s stock basis under section 961(b)(1) without regard to how that basis was originally created.
  • Transition rules for annual PTEP accounts maintained before the applicability date of the regulations.

Ordering of E&P upon distribution and reclassification

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.
  • A “last in, first out” (LIFO) approach will generally be applied to the sourcing of distributions from annual PTEP accounts. PTEP attributable to income inclusions under section 965(a) or by reason of section 965(b)(4)(A), however, will receive priority when determining the group of PTEP from which a distribution is made.
  • Starting with section 959(c)(1) PTEP, distributions will be sourced first from the reclassified Section 965(a) PTEP and then from the 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 then be sourced from section 959(c)(2) PTEP. Similar to the rules described above, distributions will be sourced first from 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.
  • When all the PTEP groups have been exhausted, the remaining amount of any distributions will be sourced from section 959(c)(3) E&P, to the extent thereof.
  • The special priority rule and LIFO rules also apply when PTEP is reclassified from section 959(c)(2) PTEP to section 959(c)(1) PTEP.

Adjustments due to a GILTI inclusion in excess of current E&P

GILTI inclusions, unlike subpart F inclusions, are not limited by current-year E&P. As such, a U.S. shareholder’s GILTI inclusion amount may exceed the CFC’s current-year E&P and, in some cases, the CFC’s accumulated E&P.

Section 3.03 of the Notice provides that the aggregate of the amounts of section 959(c)(1) PTEP, section 959(c)(2) PTEP, and section 959(c)(3) E&P must equal the CFC’s E&P. Section 3.03 of the Notice also notes that:

  • Current E&P is first classified as section 959(c)(3) E&P and then section 959(c)(3) E&P is reclassified as section 959(c)(1) PTEP or section 959(c)(2) PTEP, as appropriate, in full, which may create or increase a deficit in section 959(c)(3) E&P. Thus, where a current-year GILTI inclusion exceeds available section 959(c)(3) E&P, that balance would become negative in order to allow for the creation of the appropriate PTEP while maintaining the correct total E&P.
  • If a CFC 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.

Obviously, these rules are extraordinarily complex and could create enormous recordkeeping burdens depending on the taxpayer’s facts. While the rules set forth in the Notice are not mandatory, they are likely to form the basis for whatever final regulatons the IRS and Treasury adopt to account for the earnings of a foreign corporation, and taxpayers should consider whether adopting the rules prior to issuance provides a benefit. However, taxpayers will need to model the application of the rules using their specific facts to determine whether they may benefit from their application.

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