Treasury Issues Guidance on Previously Taxed Earnings and Profits Arising from the Enactment of TCJA

December 2018


Summary

Recently, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury) issued Notice 2019-01 (the Notice). The Notice provides that Treasury intends to issue regulations addressing certain issues arising from the enactment of the 2017 tax reform known as the Tax Cuts and Jobs Act (TCJA), with respect to foreign corporations with previously taxed earnings and profits (PTEP). This alert summarizes some of the important rules contained in the Notice.
 

Details

General Rules
 
The term PTEP refers to earnings and profits (E&P) of a foreign corporation attributable to amounts which are, or have been, included in the gross income of a U.S. shareholder (as defined under Section 951(b)) under Section 951(a) or under Section 1248(a).[1] Under Section 959(a)(1), distributions of PTEP are excluded from the U.S. shareholder’s gross income, or the gross income of any other U.S. person who acquires the U.S. shareholder’s interest (or a portion thereof) in the foreign corporation (such U.S. person, a successor in interest). Section 959(a)(2) further excludes PTEP from a U.S. shareholder’s gross income if such E&P would be included in the gross income of the U.S. shareholder or successor in interest under Section 951(a)(1)(B) as an amount determined under Section 956. Distributions of PTEP to a U.S. shareholder or successor in interest generally are not treated as dividends except that such distributions immediately reduce the E&P of the foreign corporation.[2]
 
Section 959(c) ensures that distributions from a foreign corporation are first attributable to PTEP described in Section 959(c)(1) (Section 959(c)(1) PTEP) and then to PTEP described in Section 959(c)(2) (Section 959(c)(2) PTEP), and finally to non-previously taxed E&P (Section 959(c)(3) E&P). In addition, Section 959(f) ensures that, in determining the amount of any inclusion under Sections 951(a)(1)(B) and 956 with respect to a foreign corporation, PTEP attributable to Section 951(a)(1)(A) inclusions remaining after any distributions during the year are taken into account before non-previously taxed E&P described in Section 959(c)(3).
 
The Notice provides that Treasury intends to withdraw existing proposed regulations and issue new proposed regulations under Sections 959 and 961 that provide rules regarding (1) annual accounts and groups of PTEP, (2) ordering of E&P upon distributions and reclassifications and (3) adjustments due to an income inclusion in excess of current E&P.
 
Annual Accounts and Groups of PTEP
 
The TCJA created the need to account for new groups of PTEP because Section 959(c)(2) PTEP may arise by reason of income inclusions under Section 951(a)(1)(A), 245A(e)(2), 951A(f)(1), 959(e), 964(e)(4), or 965(a), or by reason of the application of Section 965(b)(4)(A), and those different groups of PTEP may be subject to different rules under Sections 960, 965(g), 245A(e)(3), and 986(c). Additionally, because Section 959(c)(2) PTEP may be reclassified as Section 959(c)(1) PTEP as a result of Sections 956 and 959(a)(2), 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. Groups of Section 959(c)(1) PTEP must also be maintained with respect to inclusions under Section 951(a)(1)(B) and Section 951(a)(1)(C) (before its repeal) (in such cases, not by reason of the application of Section 959(a)(2) or Section 959(a)(3) (before its repeal)).
 
The Notice provides that the forthcoming regulations will provide that an annual account (each an annual PTEP account) must be maintained and each annual PTEP account must be segregated into the 16 groups described below in each Section 904 category (individually, a PTEP group and collectively, PTEP groups).
 
These 16 groups include:
  1. E&P described in Section 959(c)(1)(A) that were initially described in Section 959(c)(2) by reason of Section 965(a) (reclassified Section 965(a) PTEP);
  2. E&P described in Section 959(c)(1)(A) that were initially described in Section 959(c)(2) by reason of Section 965(b)(4)(A) (reclassified Section 965(b) PTEP);
  3. E&P described in Section 959(c)(1)(A) by reason of Section 951(a)(1)(B) and not by reason of Section 959(a)(2) (Section 951(a)(1)(B) PTEP);
  4. E&P described in Section 959(c)(1)(A) that were initially described in Section 959(c)(2) by reason of Section 951A(f)(2) (reclassified Section 951A PTEP);
  5. E&P described in Section 959(c)(1)(A) that were initially described in Section 959(c)(2) by reason of Section 245A(e)(2) (reclassified Section 245A(e)(2) PTEP);
  6. E&P described in Section 959(c)(1)(A) that were initially described in Section 959(c)(2) by reason of Section 959(e) (reclassified Section 959(e) PTEP);
  7. E&P described in Section 959(c)(1)(A) that were initially described in Section 959(c)(2) by reason of Section 964(e)(4) (reclassified Section 964(e)(4) PTEP);
  8. E&P described in Section 959(c)(1)(A) that were initially described in Section 959(c)(2) by reason of Section 951(a)(1)(A) (other than E&P that were initially described in (10) through (15) of this list) (reclassified Section 951(a)(1)(A) PTEP);
  9. E&P described in Section 959(c)(1)(B), including by reason of Section 959(a)(3) (before its repeal) (Section 956A PTEP);
  10. E&P described in Section 959(c)(2) by reason of Section 965(a) (Section 965(a) PTEP);
  11. E&P described in Section 959(c)(2) by reason of Section 965(b)(4)(A) (Section 965(b) PTEP);
  12. E&P described in Section 959(c)(2) by reason of Section 951A(f)(2) (Section 951A PTEP);
  13. E&P described in Section 959(c)(2) by reason of Section 245A(e)(2) (Section 245A(e)(2) PTEP);
  14. E&P described in Section 959(c)(2) by reason of Section 959(e) (Section 959(e) PTEP);
  15. E&P described in Section 959(c)(2) by reason of Section 964(e)(4) (Section 964(e) PTEP); and
  16. E&P described in Section 959(c)(2) by reason of Section 951(a)(1)(A) not otherwise described in (10) through (15) of this list (Section 951(a)(1)(A) PTEP).
 
Accordingly, after the TCJA, Section 959(c)(1) PTEP will be comprised of PTEP groups described in (1) through (9) of the preceding paragraph, and Section 959(c)(2) PTEP will be comprised of PTEP groups described in (10) through (16) of the preceding paragraph. The forthcoming regulations will provide that 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) (including by reason of Section 245A(e)(2), 951A(f)(1), 959(e), 964(e)(4), or 965(a)) 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 taxable year. See also proposed §§1.960-3(c)(3) and 1.960-3(c)(4) which provide similar rules for purposes of determining the amount of foreign income taxes deemed paid under Section 960(b).
 
Proposed §1.960-3(c) provides that, for purposes of determining the amount of foreign income taxes deemed paid under Section 960(b), with respect to a CFC, a separate annual PTEP account is maintained in each relevant Section 904 category and the PTEP in each such account is assigned to one or more of the PTEP groups. The Notice provides that the forthcoming regulations will 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 E&P in each Section 904 category. Additionally, the rules in proposed §§1.960-1 and 1.960-3 addressing the types of PTEP groups and their treatment for purposes of applying Section 960(b) will be coordinated, as appropriate, with the forthcoming regulations when finalized.
 
Treasury states in the Notice that it is expected that forthcoming regulations will provide that dollar basis must be tracked for each annual PTEP account, and, to the extent provided in the forthcoming regulations, separately for each PTEP group within an annual account. The forthcoming regulations will confirm that distributions from any PTEP group reduce the shareholder’s stock basis under Section 961(b)(1) without regard to how that basis was originally created, including if the basis was created under Section 961(a) due to an inclusion unrelated to the PTEP group being distributed.
 
The Notice also provides that forthcoming regulations are expected to provide transition rules for annual PTEP accounts maintained before the applicability date of the regulations. The Notice includes details relating to these transition rules. See section 3.01 of the Notice for additional details.
 
Ordering Rules
 
The Notice states that forthcoming regulations will clarify that a distribution will be a distribution of PTEP only to the extent it would have otherwise been a dividend under Section 316. For example, if a foreign corporation has no current E&P or accumulated E&P at the end of a taxable year, a distribution from the corporation to a shareholder during the taxable year will be a return of basis or treated as gain from the sale or exchange of property under Section 301(c)(2) or (3), respectively, regardless of whether the shareholder has one or more annual PTEP accounts with respect to its stock in the foreign corporation.
 
To facilitate the rule in Section 959(c), which incorporates the ordering rule of Section 316, the forthcoming regulations will require a “last in, first out” approach to the sourcing of distributions from annual PTEP accounts, subject to the special priority rule for PTEP arising by reason of the application of Section 965, as discussed below.
 
The Notice provides that the forthcoming regulations will provide that PTEP attributable to income inclusions under Section 965(a) or by reason of Section 965(b)(4)(A) receive priority when determining the group of PTEP from which a distribution is made. This priority will be integrated into the general ordering rule of Section 959(c) that sources PTEP first from Section 959(c)(1) PTEP and then from Section 959(c)(2) PTEP. Thus, starting with Section 959(c)(1) PTEP, under the forthcoming regulations, as an exception to the last-in, first-out approach, 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 last-in, first-out 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 be sourced from Section 959(c)(2) PTEP. The Notice further provides that the forthcoming regulations will provide that, as an exception to the last-in, first-out approach, 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 last-in, first-out 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. Finally, once 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 forthcoming regulations will also provide that reclassifications of PTEP pursuant to the application of Section 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.
 
Adjustment Rules
 
The Notice provides that the forthcoming regulations under Section 959 will 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 have the effect of creating or increasing a deficit in Section 959(c)(3) E&P. For a similar rule in the case in which a U.S. shareholder’s inclusion under Section 951(a) by reason of Section 965(a) exceeds E&P, see proposed §1.965-2(d)(1).
 
The Notice also states that in a case where 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. See the examples included in section 3.04 of the Notice for additional details.
 
Applicability Date
 
The forthcoming regulations are expected to apply to taxable years of U.S. shareholders (and successors in interest) ending after December 14, 2018, and to taxable years of foreign corporations ending with or within such taxable years of U.S. shareholders.[3] Before the issuance of the forthcoming regulations, a shareholder may rely on the rules described in Section 3 of the Notice if the shareholder and each person related to the shareholder under Section 267(b) or 707(b) (each such person, a related shareholder) apply the rules consistently with respect to PTEP of all foreign corporations in which the shareholder or related shareholder, as the case may be, owns stock for all taxable years beginning with the shareholder’s or the related shareholder’s taxable year that includes the taxable year end of any such foreign corporation to which Section 965 applies.
 

BDO Insights

To implement all of the operative provisions relating to PTEP following the TCJA requires an incredibly complex set of rules, both from an administrative and compliance perspective. The Notice states that Treasury is considering ways to simplify the rules associated with PTEP by consolidating PTEP groups or grouping accounts into multi-year accounts, or by other methods and Treasury is requesting comments in this regard.
 

CONTACT:
 
Joe Calianno
Partner and International Tax Technical Practice Leader
National Tax Office
  Monika Loving
Partner and International Tax Practice Leader
 

 
Brandon Boyle
Principal
  Annie Lee
Partner

 
Chip Morgan
Partner
  Robert Pedersen
Partner

 
Jerry Seade
Principal
  Natallia Shapel
Partner

   
Sean Dokko
Senior Manager
National Tax Office
   
 
[1] See Sections 959(a) and (e).
[2] Section 959(d).
[3] See Section 7805(b)(1)(C).