Proposed PTEP rules address TCJA provisions, longstanding issues

The IRS published the long-anticipated proposed regulations regarding previously taxed earnings and profits (PTEP) of foreign corporations and related basis adjustments on Dec. 2, 2024 (REG-105479-18). The regulations are anticipated to be the first in a series of packages providing rules to address foundational aspects of the PTEP system. They resolve longstanding issues under Sections 959 and 961 and incorporate new guidance addressing changes made under the Tax Cuts and Jobs Act (TCJA).

The PTEP system is a critical component to the controlled foreign corporation (CFC) regime, designed to prevent shareholders (or successors) from incurring double taxation. When a foreign corporation distributes amounts to a U.S. shareholder that would otherwise be treated as a dividend, the PTEP rules generally exclude from gross income any amounts that have previously been included in gross income of such U.S. shareholder under Section 951(a) and subject to tax.

The existing PTEP regulations, issued in 1965 and 1971 and partially amended in 1983, remain largely outdated and were insufficient to address current complexities. The TCJA also marked a monumental shift for international tax law; it was the most significant overhaul to the system since 1986. The IRS has provided limited guidance over the years with rules related to PTEP and basis adjustments in Notice 1988-71 (the 1988 Notice), operational rules in Notice 2019-01 (the 2019 Notice), and rules addressing various issues in 2006 proposed regulations, which were subsequently withdrawn on Oct. 21, 2022.

Future packages are expected to provide guidance on certain issues not addressed in the proposed regulations, including issues involving nonrecognition transactions, redemptions, transactions to which Section 964(e) applies; as well as structures where CFCs are partners in a partnership.

The rules in the proposed regulations are generally applicable once finalized but contain an earlier effective date for the portions covered in the 2019 Notice. The preamble notes that taxpayers cannot rely on the proposed regulations, nor can taxpayers early adopt before the regulations are finalized. 

Section 959 proposed regulations

Under Section 959, amounts of E&P deemed included in the gross income of a U.S. shareholder under Section 951(a) are treated as PTEP. Common sources of deemed inclusions that give rise to PTEP include Subpart F income, Global Intangible Low-Taxed Income (GILTI), inclusions under Section 965 (commonly referred to as the “one-time transition tax,” or “mandatory repatriation tax”), and gain recognized on a sale or exchange of foreign corporation stock under Section 1248.  Section 959 ensures that income earned by a CFC and taxed at the U.S. shareholder level under one of the deemed inclusion rules is not subject to taxation again when distributed to the U.S. shareholder.

The proposed regulations under Section 959 introduce complex rules for PTEP accounting at both the shareholder and foreign corporation levels, determining exclusions from gross income of distributions and provide other operating rules.

Shareholder-level PTEP accounts

At the shareholder level, the proposed regulations require the annual maintenance of PTEP accounts, dollar basis pools, and PTEP tax pools for each foreign corporation in which the “covered shareholder” owns stock. Under the proposed regulations, a “covered shareholder” is defined as any U.S. person (as described in Section 7701(a)(30)), except for domestic partnerships. In addition, the proposed regulations treat an S corporation in the same manner as a domestic partnership. Because domestic partnerships are treated as aggregates of their partners in determining stock ownership for purposes of Section 959, they are not considered covered shareholders.

Shareholder-level PTEP accounts represent PTEP that is directly or indirectly distributable exclusively to the covered shareholder, or a successor. Under the successor rules, PTEP accounts and the related dollar basis pools and PTEP tax pools can be transferred to another covered shareholder. According to the proposed regulations, a successor transaction generally occurs when a successor covered shareholder acquires stock in one or more foreign corporations that, immediately prior to the transaction, was owned by a transferor covered shareholder. In addition, special “deemed covered shareholder” rules apply in cases involving intervening foreign ownership, such as when a covered shareholder transfers foreign corporation stock to a foreign person who subsequently transfers that stock to another covered shareholder.

Annual PTEP accounts

Maintaining annual PTEP accounts is necessary for determining foreign currency gain or loss and foreign tax credits with respect to distributed PTEP.  Each shareholder-level PTEP account relates to a single tax year and a single Section 904 category. Within each annual PTEP account, PTEP is maintained in the foreign corporation’s functional currency and is assigned among 10 PTEP groups and two subgroups. This is a reduction from the 16 PTEP groups originally provided in the 2019 Notice. The two subgroups track taxable Section 962 PTEP and Section 1411(c) PTEP, both of which arise from income inclusions of certain individual, estate, and trust covered shareholders.

PTEP distributions are generally sourced from the covered shareholder’s annual accounts on a last-in, first-out (LIFO) basis beginning with Section 959(c)(1) PTEP and then Section 959(c)(2) PTEP, subject to an exception for the Section 965 priority rule. The Section 965 priority rule was retained from the 2019 Notice to “simplify” PTEP recordkeeping. If a PTEP group contains E&P in multiple Section 904 categories that have the same priority in a given year, the distribution is sourced on a pro rata basis from each category.

The 10 PTEP groups are divided into Section 959(c)(1) PTEP groups and Section 959(c)(2) PTEP groups, which are as follows: 

Dollar-basis pools and PTEP tax pools

In addition to tracking shareholder PTEP accounts in functional currency, the proposed regulations require maintaining both the dollar-basis pools and PTEP tax pools be on a U.S. dollar (USD) basis for each covered shareholder. The dollar-basis pools are used to determine foreign currency gain or loss under Section 986(c) and to determine basis adjustments under Section 961.

The proposed regulations also introduce a new shareholder-specific framework for tracking foreign income taxes associated with PTEP, which is consistent with the approach used for annual PTEP accounts. This approach represents a departure from the current method under existing Treas. Reg. Sec. 1.960-3 (and the 1988 Notice), where foreign income taxes related to PTEP are tracked only at a CFC level. Similar to the annual PTEP accounts, both the dollar-basis pools and PTEP tax pools are maintained on a year-by-year basis, with one pool for each PTEP group within each annual PTEP account.

The proposed regulations offer an election “intended to simplify PTEP accounting,” which can be made by a covered shareholder with respect to all foreign corporations for which such covered shareholder holds an interest. Under this election, each dollar-basis pool and PTEP tax pool is assigned to a single PTEP group and a single Section 904 category, regardless of the taxable years to which the PTEP relates. Once made, the combined pool election may only be revoked with the Commissioner’s consent.

Shareholder-level PTEP adjustments

The proposed regulations provide guidance on how a covered shareholder must adjust its annual PTEP accounts, as well as its dollar-basis pools and PTEP tax pools with respect to a foreign corporation. These adjustments are made at one of three points in time:

1. At the beginning of the foreign corporation’s year
2. At the time of certain transactions
3. At the end of the foreign corporation’s year

In applying these rules to tiers of foreign corporations, the adjustments are applied successively from the lowest tier foreign corporation to the highest-tier foreign corporation.

Beginning-of-year adjustments

Beginning of year adjustments are made at the start of the first day of the foreign corporation’s taxable year. These adjustments most commonly include PTEP arising from a covered shareholder’s Subpart F or GILTI inclusions.  Other adjustments treated as made at the beginning of the year include PTEP resulting from distributions to the foreign corporation received during the taxable year as well as PTEP of a covered shareholder arising from the application of the foreign corporation’s Sec. 961(c) basis to gain recognized by the foreign corporation during the taxable year.

Time-of-transaction adjustments

Three types of PTEP adjustments occur concurrently with the transaction occurring during the foreign corporation’s taxable year. These include:

1. PTEP distributed by the foreign corporation
2. PTEP arising from gain recognized by the covered shareholder that is recharacterized as a dividend under Section. 1248
3. PTEP transferred to or from the covered shareholder under the successor rules

In the preamble to the proposed regulations, the IRS indicated that it continues to study the application of Section 959(b) to situations where the foreign corporation was a CFC when PTEP was generated but is no longer a CFC when the PTEP is distributed. The IRS noted that this treatment is required to give effect to Section 959(a), ensuring that “PTEP remains PTEP.” The proposed regulations also provide special rules for distributions of PTEP in a split ownership structure.

End-of-year adjustments

Two types of adjustments are treated as being made at the end of the last day of a foreign corporation’s taxable year, both relating to Section 956 amounts:

• PTEP to which a Section 956 amount is allocated and is reassigned within annual PTEP accounts from Section 959(c)(2) PTEP groups to Section 959(c)(1) PTEP groups
• PTEP arising from the Section 956 amount included in a covered shareholder’s gross income under Section 951(a)(1)(B).

Foreign corporation-level accounts  

The proposed regulations also require the maintenance of PTEP accounts and associated foreign income taxes at the foreign corporation level. These foreign corporate-level accounts are necessary to allocate and apportion current-year taxes paid or accrued by a foreign corporation among its relevant statutory and residual groupings, as well as for performing computations under Section 956. Foreign corporation-level PTEP accounts and PTEP tax pools represent all PTEP within a covered shareholder’s annual PTEP accounts and PTEP tax pools with respect to such foreign corporations. The proposed regulations also provide that foreign corporate-level accounts are not required for E&P described in Section 959(c)(3).

Section 961 proposed regulations

The proposed regulations under Section 961 adjust the basis in shares of stock of a foreign corporation owned by a covered shareholder, as well as the basis in any items of property through which the covered shareholder owns stock of the foreign corporation, to reflect the foreign corporation’s PTEP with respect to a covered shareholder. Unlike annual PTEP accounts, basis adjustments under the proposed regulations are specific to a share of stock or other item of property, consistent with each item of property having a separate basis under the Code.

The proposed regulations provide rules for three distinct types of basis, which depend on whether the direct owner of such item is a covered shareholder, a partnership, or a CFC. Each type of basis is maintained with respect to the following ownership units:

1. Section 961(a) ownership unit:

• A share of stock of a foreign corporation directly owned by a covered shareholder
• A partnership interest directly owned by a covered shareholder, through which the covered shareholder owns stock of a foreign corporation

2. Derivative ownership unit:

• A share of foreign corporation stock directly owned by a partnership and indirectly owned by one or more covered shareholders through only one or more partnerships
• A partnership interest directly owned by another partnership, through which one or more covered shareholders own foreign corporation stock only through partnerships

3. Section 961(c) ownership unit:

• A share of foreign corporation stock directly owned by a CFC and indirectly owned by one or more covered shareholders

The three distinct types of basis are: adjusted basis, derived basis, and Section 961(c) basis. The proposed regulations provide that derived basis and Section 961(c) basis are maintained separately with respect to each covered shareholder. Both types of basis may be positive or negative. Derived basis is an attribute of the partnership, but it does not affect the partnership’s common basis in the derivative ownership unit or any other asset of the partnership. Section 961(c) basis is a CFC-level attribute. The following examples illustrate the three types of basis:

Basis adjustments under Section 961(a), (b) and (c)

The proposed regulations provide complex rules for increasing basis adjustments. The regulations provide a four-step approach under which a taxpayer:

1. Determines the amount of income inclusions giving rise to increases to basis
2. Determines if any “midyear transactions” (which affect the timing of certain basis adjustments) occur within the relevant taxable year (e.g., a sale, exchange, or other disposition or stock during the year)
3. Applies the “actual distribution rule”
4. Applies the “hypothetical distribution rule.”

Under these rules, basis is increased to reflect a covered shareholder’s income inclusion under Sections 951(a) and 951A(a). Basis is first increased under an “actual distribution rule” where a PTEP distribution is made before the last relevant day of the CFC’s taxable year. After application of the actual distribution rule, the taxpayer increases basis under the hypothetical distribution rule for any remaining portion of the income inclusions giving rise to increases to basis.

The actual distribution rule basis adjustment amount is generally the amount of the adjustment required under Treas. Reg. Sec. 1.961-4 (basis reductions and gain recognition for distributions) to such basis by reason of the distribution. The hypothetical distribution rule then requires the basis of each property unit be increased by any remaining amount that would be distributed, after the actual distributions, with respect to the property unit in a hypothetical distribution. The hypothetical distribution is treated as made through all tiers to the covered shareholder on the last relevant day of the CFC’s taxable year.

Generally, each basis increase under the hypothetical distribution rule or actual distribution rule is treated as made at the beginning of the first day of the CFC’s taxable year. However, there are various exceptions that may apply that would require the adjustment to be made at other times during the year.

The proposed regulations also introduce specific rules governing basis reduction and gain recognition under Section 961(b). When a covered shareholder receives a PTEP distribution excluded from gross income under Section 959(a), the covered shareholder’s adjusted basis in each Section 961(a) ownership unit is generally reduced by the corresponding dollar basis and associated foreign income taxes of the distributed PTEP.

The proposed regulations also provide specific rules for basis adjustments related to foreign currency gains or losses and the transfer of basis in a general successor transaction.

In a CFC’s disposition of Section 961(c) ownership units, the proposed regulations provide that gain for which positive Section 961(c) basis is applied is treated as PTEP that is generally excluded from the CFC’s gross income under Section 961(c). The Section 961(c) rules are similar to those described above, however, as noted above, Section 961(c) basis can become negative.

The proposed regulations clarify that Section 961(c) basis applies for purposes of determining the CFC’s Subpart F income and tested income or tested loss. Under the proposed regulations, any gains in excess of basis or gains triggered by negative Section 961(c) basis are defined as Section 961(c) income to the U.S. shareholder. A U.S. shareholder owning stock of a CFC on the last relevant day must include in gross income its allocated amount of the CFC’s Section 961(c) income, reduced by any loss the CFC is treated as recognizing under Section 961(c) for that shareholder, in the same manner as a Subpart F inclusion. This inclusion increases basis in the U.S. shareholder’s stock of the CFC and any intermediary property units, but does not increase a CFC’s PTEP, as the Section 961(c) income does not give rise to E&P at the CFC level.

Partnership basis adjustments

The proposed regulations also address basis adjustments when a covered shareholder owns a foreign corporation through a partnership and the partnership disposes of its shares in the foreign corporation. A partnership has derived basis in a derivative ownership unit, which is maintained separately with respect to each covered shareholder that owns the derivative ownership unit through one or more partnerships. Under the proposed regulations, a partnership must increase its derived basis with respect to a covered shareholder partner to reflect that partner’s Subpart F and GILTI inclusions and must decrease its derived basis to account for PTEP distributions.

In a partnership’s disposition of derivative ownership units, each partner’s distributive share of gain or loss is first determined under Section 704, taking into account any Section 743(b) basis adjustment with respect to the partner, but disregarding the positive derived basis. Then, positive derived basis is applied to each covered shareholder’s distributive share of such gain or loss, subject to certain limitations. If the partnership has negative derived basis, the proposed regulations provide rules that treat the partnership as recognizing gain from the disposition of derivative ownership units.

The regulations also contain a variety of rules addressing related partnership issues, including tiered partnership structures and coordination with Section 705, among others. 

Transition rules

The proposed regulations include transition rules under Section 959 for establishing and conforming accounts under Section 959, and rules under Section 961 for establishing derived basis and Section 961(c) basis.

As of the beginning of the first taxable year in which the proposed regulations apply (whether under the 2019 Notice or through early application), a reasonable method must be used to establish annual PTEP accounts, dollar-basis pools, and corporate PTEP accounts in accordance with the proposed regulations. This method must also reflect any prior adjustments that would have been made under the principles of those proposed regulations.

The proposed regulations also require the establishment of a partnership’s derived basis or a CFC’s Section 961(c) basis as of the beginning of the first taxable year of a foreign corporation to which the proposed Section 961 regulations apply or the early application option. Basis is determined as the amount that would exist in the property unit if the principles of the applicable proposed Section 961 regulations were to have applied for all prior periods, using a reasonable and consistent method. 

Other issues

The proposed PTEP regulations also cover several other areas, including:•  Guidance under Section 986(c) regarding the distribution of PTEP

• Rules for applying Treas. Reg. §1.861-20 to allocate and apportion current-year taxes to statutory groupings of PTEP, as outlined in Treas. Reg. §1.861-8(a)(4)
• Guidance related to consolidated returns
• Specific provisions regarding the application of Section 962
• Anti-avoidance rules aimed at preventing misuse of PTEP provisions
• Transition rules addressing partnerships with both entity level and aggregate approach PTEP

Applicability dates

The 2024 proposed regulations generally apply to taxable years of foreign corporations beginning on or after the date the proposed regulations are finalized. Portions of the proposed regulations that apply to the 2019 Notice generally apply to taxable years of U.S. shareholders for years ending after Dec. 14, 2018, and taxable years of foreign corporations ending with or within those taxable years.

Taxpayers may choose to early apply the proposed regulations, when finalized, in their entirety to an earlier year and all succeeding early application years. The proposed regulations also provide that all taxable years of covered shareholders for which the early application years are relevant must be open under Section 6501 and that each covered shareholder must confirm in a written statement to the foreign corporation that also provides the covered shareholder’s consent to apply the proposed regulations before the general applicability date.