Sec. 956 and Subpart F Inclusions, Actual Distributions, and Previously Taxed Income

By Hui Yu, J.D., LL.M., Washington

Editor: Annette B. Smith, CPA

Foreign Income & Taxpayers

Under Sec. 959(a), a distribution by a controlled foreign corporation (CFC) out of earnings and profits (E&P) that have been included in the income of a U.S. shareholder, commonly referred to as previously taxed income (PTI), is not included in the U.S. shareholder's income a second time. The PTI rules were designed to prevent double taxation of a CFC's earnings. Keeping track of a foreign corporation's E&P under the Sec. 959 ordering rules can be complicated, with different categories of PTI as well as non-PTI.

A CFC's E&P can be divided into three categories, commonly known as:

  • Sec. 959(c)(1) account, from prior-year Sec. 956 inclusions;
  • Sec. 959(c)(2) account, from current- or prior-year subpart F income inclusions and Sec. 1248 deemed-dividend inclusions; and
  • Sec. 959(c)(3) account (other E&P, i.e., non-PTI).

Under the ordering rules, an actual distribution is treated as made first out of the Sec. 959(c)(1) account, then out of the Sec. 959(c)(2) account, and finally out of the Sec. 959(c)(3) account. Within each Sec. 959(c) account, PTI is considered distributed on a last-in, first-out (LIFO) basis.

Example: USP , a U.S. corporation, owns 100% of CFC1 , a foreign holding company that is a CFC. CFC1 owns CFC2 , another CFC and an operating company. CFC2 has owned 100% of DC , a U.S. corporation, since Jan. 1, year 1, with an adjusted basis of $3 in its DC stock. CFC2 has E&P of $10 in year 1. During year 2, CFC1 earns subpart F income of $5; CFC1 makes a distribution of $50 to USP on June 1; CFC2 makes a distribution of $6 to CFC1 on Dec. 1; CFC2 makes an entity classification election to be disregarded as an entity separate from its owner, CFC1 , on Dec. 15; and CFC2 sells 100% of DC stock to a third party for cash at fair market value on Dec. 30, realizing a gain of $4.

Year 1

CFC2' s ownership of shares in DC constitutes an investment in U.S. property under Sec. 956, giving USP a Sec. 956 inclusion to the extent of the lesser of (1) CFC2' s E&P or (2) the adjusted basis of CFC2 in DC stock, which is $3 in year 1. This Sec. 956 inclusion in year 1 becomes CFC2' s PTI in year 2-Sec. 959(c)(1) PTI.

Year 2

Generally, under Sec. 959(f)(2), actual distributions during the year are taken into account before current-year Sec. 956 inclusions. Therefore, $3 of the Dec. 1, year 2, distribution of $6 from CFC2 to CFC1 should be treated as made out of PTI from the year 1 Sec. 956 inclusion, and the remaining $3 of that distribution should be excepted from subpart F income under the CFC lookthrough rule of Sec. 954(c)(6). CFC1' s Sec. 959(c)(1) PTI account thus is increased to $3 (the year 1 Sec. 956 PTI), while CFC2' s Sec. 959(c)(1) PTI account is reduced to zero before considering the year 2 Sec. 956 inclusion.

Assuming that CFC2 is solvent at the time, the election to treat CFC2 as a disregarded entity should be treated as a Sec. 332 liquidation of CFC2 into CFC1 , occurring immediately before the close of the day before the election is effective on Dec. 14, year 2. Assuming the year 2 Sec. 956 inclusion from CFC2' s shareholding in the DC stock equals $3, CFC2' s earnings of $3 invested in U.S. property became accumulated and PTI on Dec.14, year 2 (the year 2 Sec. 956 PTI).

Under Regs. Sec. 1.381(c)(2)-1(a)(2), if the distributor has accumulated E&P as of the close of the distribution date, that E&P is deemed to become the accumulated E&P of the acquiring corporation at that time. Therefore, the year 2 Sec. 956 PTI became CFC1' s accumulated E&P and Sec. 956 PTI on Dec. 14, year 2.

Can CFC1 Use the Year 2 Sec. 956 PTI for Its Distribution to USP on June 1, Year 2?

Under Sec. 316(a), for a distribution to be a dividend during a tax year, CFC1 must have access to (1) any E&P accumulated as of the date of the distribution or (2) current E&P computed at the end of the tax year. The treatment of PTI in a deemed liquidating distribution is reserved under Regs. Sec. 1.367(b)-7(b)(2). Because the year 2 Sec. 956 PTI ( CFC1' s accumulated, as opposed to current, E&P) had not been accumulated on the date of the distribution, CFC1 technically does not seem to have access to the year 2 Sec. 956 PTI for the June 1 distribution to USP under the Sec. 316(a) rule.

However, it can be argued on policy grounds that CFC1 should be able to access the year 2 Sec. 956 PTI for its distribution to USP on June 1, year 2. First, such a result would be supported by the legislative intent behind Sec. 959-to avoid double taxation and allow U.S. persons "to receive the full benefit of their PTI at the earliest possible time" (71 Fed. Reg. 51,155 (Aug. 29, 2006)). Second, under Regs. Sec. 1.959-3(b)(3), an actual distribution of previously taxed Sec. 956 inclusion from a lower-tier CFC to an upper-tier CFC is classified as PTI in the Sec. 959(c)(1) account of the upper-tier CFC. Similarly, the distribution in a deemed liquidation should be treated the same so that the year 2 Sec. 956 PTI should be classified as CFC1' s Sec. 959(c)(1) account for year 2 and thus available for CFC1' s distributions during year 2, including the one on June 1.

Sale of the DC Stock

Because CFC1 will not own any DC stock over a quarter end, USP should not have a Sec. 956 inclusion resulting from CFC1' s shareholding (through its disregarded entity, CFC2 ) in the DC stock during the time between the entity classification election and the DC sale.

The $4 gain realized from the DC sale by CFC2/CFC1 in December year 2 should be treated as subpart F income, giving rise to a current-year U.S. inclusion in year 2 that should be foreign-source passive income. This current-year foreign-source subpart F income inclusion becomes CFC1' s Sec. 959(c)(2) PTI of $4 for year 2. The gain on the DC sale increases CFC1' s current-year E&P, and, under the ordering rules described above, the subpart F income inclusion should be the first use of CFC1' s current-year E&P.

Assuming that CFC1' s E&P at the end of year 2 exceeds $50, for year 2:

  • CFC1' s current-year subpart F income of $9-$5 of subpart F income earned by CFC1 in year 2 plus $4 of gain from the DC sale by CFC1 -is included in USP' s income;
  • Sec. 959(c)(1) account: $6 (the year 1 Sec. 956 PTI plus the year 2 Sec. 956 PTI) of the distribution of $50 from CFC1 to USP is not included in USP' s income a second time;
  • Sec. 959(c)(2) account: $9 (subpart F income PTI plus gain from the DC sale) of the distribution of $50 from CFC1 to USP is not included in USP' s income a second time; and
  • Sec. 959(c)(3) account: The remaining $35 out of the $50 distribution from CFC1 to USP is untaxed E&P of CFC1 and is included in USP' s income.


Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.

For additional information about these items, contact Ms. Smith at 202-414-1048 or

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.

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