Treasury Releases Proposed PTEP and Basis Regulations

On Nov. 29, 2024, the U.S. Treasury released proposed regulations REG-105479-18 that would clarify long-standing questions surrounding previously taxed earnings and profits (PTEP) and the corresponding basis adjustments. The PTEP rules address issues that arise from the inclusion of income from certain income taxation regimes that involve undistributed earnings. Internal Revenue Code (IRC) Section 951(a) (Subpart F), Section 951A (GILTI) and Section 965 (the Transition Tax) are examples of tax regimes that require U.S. shareholders to immediately recognize certain types of income from Controlled Foreign Corporations (CFCs), which are foreign corporations in which certain U.S. shareholders own, in the aggregate, at least 50% of the value (or voting rights) of the shares of stock. Moreover, income must be immediately recognized under those regimes even if no distribution is made.

The PTEP and stock adjustment provisions under IRC Sections 959 and 961 are designed to alleviate additional tax burdens caused by the earlier income recognition when distributions of PTEP from the CFCs occur later, or when there is a sale of CFC stock of a corporation with undistributed PTEP. Typically, IRC Section 959 provides that distributions that come out of PTEP are not taxable again to the U.S. shareholder, although exceptions exist (e.g., situations involving an IRC Section 962 election). In addition, the U.S. shareholder will receive an increase in its tax basis of the CFC stock for the amount of income recognized prior to any distribution. The proposed regulations address many (but not all) of the questions that arise from the PTEP rules.

Benefits of Stock Basis Adjustments Under the PTEP Rules

A common question among affected taxpayers is how to allocate the benefits of stock basis adjustments under the PTEP rules. Should the stock basis adjustments be divided equally among all shareholders of the CFC, or should the stock basis adjustments be allocated only to the U.S. shareholders who previously included income under the PTEP rules? The logical option is the latter, and the proposed regulations confirm that this was the Treasury’s intention when creating the PTEP rules. Note that this rule is not without its own complications. The tracking of PTEP is very complicated, which is discussed further below.

Tracking PTEP

PTEP tracking must be performed at both the CFC level and the U.S. shareholder level. PTEP tracking is necessary for multiple reasons, including the need to allocate the correct amount of PTEP to each U.S. shareholder and the need to calculate the foreign currency exchange gain or loss upon distribution under IRC Section 986(c). The tracking of PTEP can be extremely tedious and complicated, and there are 10 assigned PTEP groups with two subgroups. In addition, within the same type of PTEP group (e.g., IRC Section 951(a) Subpart F Income), a U.S. shareholder must track earnings and profits yearly in a U.S. dollar basis pool to properly account for foreign currency exchange gains. Foreign income taxes must also be tracked yearly by the PTEP group for potential use as a foreign tax credit. Distributions of PTEP must be allocated and sourced on a last in, first out (LIFO) approach. However, there is an election provided in the proposed regulations that would help to simplify this tracking, which would allow the U.S. shareholder to combine dollar-basis pools and tax pools related to a separate PTEP group across multiple years (rather than a year-by-year process).

Partnerships that own CFCs

As discussed, U.S. shareholders ordinarily increase the basis of their CFC stock for income recognized under the PTEP rules. A topic that has remained uncertain for many years is whether a U.S. partner of a U.S. partnership that owns a CFC may adjust the basis of the partnership interest for any CFC stock gains attributable to partnership holdings. At this time, there is no explicit authority in the IRC that accommodates this result for a partner of a partnership owning a CFC. The proposed regulations would allow such an adjustment, which would be excellent news for U.S. partners. However, it is unlikely that the U.S. partners would have enough information to perform these calculations at the time. Income inclusions required under Subpart F and GILTI are no longer calculated at the partnership level because currently, the partnership is treated as an aggregation of its partners under IRC Section 951A and Treasury Regulation 1.958-1(d). Therefore, the partnership may not have enough information to provide these adjustments to the U.S. partners, nor is there a section on Schedules K-2 or K-3 to disclose the necessary information to make such adjustments. If the regulations are finalized in their present form, partners will need additional reporting procedures to ensure these adjustments are calculated properly.

Gross-up of Earnings and Profits (E&P) for Split-Ownership CFC Structures

Under current regulations, a “gross-up” of E&P for tiered CFCs is used to differentiate PTEP from untaxed E&P at the shareholder level. Revenue Ruling 82-16 includes an example that involves a U.S. shareholder who owns 70% of an upper-tier CFC (the other 30% is owned by non-U.S. persons) which owns 100% of a lower-tier CFC. In the example, the lower-tier CFC generates $100 of Subpart F income which gives rise to a $70 income inclusion allocable to the U.S. shareholder. When the lower-tier CFC makes a subsequent $200 distribution, the U.S. taxpayer in the example is allowed to gross-up its allocable share of the distribution to ensure that it does not pick up additional Subpart F income related to the $30 of original Subpart F income that was not included by the other non-U.S. shareholder. While this gross-up mechanism arguably comes to the right answer, the proposed regulations would eliminate the need to gross-up the income, and instead would track covered distributions directly to covered shareholders, who can then match that distribution against their PTEP.

Conclusion

This article profiles only a small portion of the rules outlined in the proposed regulations. Treasury advised that taxpayers should expect additional regulations and notices to articulate additional issues. The regulations surrounding the PTEP rules are extremely complex and necessitate the expertise of international tax professionals. Please connect with the international tax experts at CBIZ for more information.