Foreign Income & Taxpayers
Undersubpart F (Secs. 951–964) of the Internal Revenue Code, subpart F income of a controlled foreign corporation (CFC) is included in its U.S. shareholders' income before the income actually is distributed to the U.S. shareholders. A CFC is a foreign corporation of which more than 50% in vote or value of the stock is owned, directly or by attribution, by U.S. shareholders. Sec. 951(b) defines "United States shareholder" as a U.S. person (including a domestic partnership—see Secs. 957(c) and 7701(a)(30)(B)) that owns, directly or indirectly, 10% or more of the foreign corporation by voting power.
Because subpart F income has been included in the U.S. shareholder's income when earned, the CFC's earnings attributable to the subpart F inclusion are commonly referred to as previously taxed income (PTI). When subpart F income is included in income of the U.S. shareholder, Sec. 961(a) increases the U.S. shareholder's basis in the CFC stock (or the basis in the property through which the U.S. shareholder is treated as owning the CFC stock under Sec. 958(a)(2)) by the amount of the subpart F inclusion. This adjustment prevents the U.S. shareholder from incurring a second tax on the same earnings if the U.S. shareholder sells its CFC stock before distribution of the PTI. Pursuant to Sec. 959(a), distributions out of PTI are not included in the U.S. shareholder's income. Once the PTI amounts actually are distributed, Sec. 961(b) reduces the U.S. shareholder's basis in the CFC stock (or other property) to reverse the basis increase under Sec. 961(a).
Application of these rules to partnerships can be tricky, in part because domestic partnerships are treated as U.S. persons, but foreign partnerships are not. Therefore, a domestic partnership can be a U.S. shareholder of a CFC and entitled to a Sec. 961(a) basis adjustment for the CFC stock it owns, but a foreign partnership, even if owned by U.S. persons, is not so entitled.
Basis Adjustments in Cases of CFC Stock Held by a Domestic Partnership
Example 1: US1 and US2, U.S. corporations, each own 50% of Domestic Partnership (DP). DP owns 100% of the outstanding stock of CFC, which earns subpart F income of $10 in year 1. In year 2, CFC distributes $10 to DP.
DP is a U.S. person and U.S. shareholder of CFC and, therefore, is required to have a subpart F inclusion of $10 for year 1. US1 and US2 take into account their distributive shares of DP's subpart F inclusion, in the amount of $5 each. Pursuant to Sec. 961(a), DP, as the U.S. shareholder, increases its basis in CFC stock—the partnership's inside basis—by $10, the amount of the subpart F inclusion. Under Sec. 705(a)(1)(A), US1's and US2's basis in DP—the partners' outside basis—is increased by their distributive shares of DP's subpart F inclusion, or $5 each.
The distribution of $10 from CFC to DP in year 2 is made out of PTI and excluded from DP's income for year 2 under Sec. 959(a). The tax-exempt nature of this distribution carries over to US1 and US2 when allocated to them (Sec. 702(b)), so US1 and US2 do not have income inclusion for that distribution in year 2. Because DP excludes the PTI distribution from gross income, DP's tax basis in CFC is reduced by the same amount, $10, under Sec. 961(b). This reduction arguably should be treated as an expenditure not deductible in computing its taxable income and not chargeable to its capital account within the meaning of Sec. 705(a)(2)(B), resulting in a corresponding decrease to the outside basis of US1 and US2 in DP.
To summarize, US1's and US2's outside basis totals $10, which corresponds to the PTI distribution from CFC that remains to be distributed to the partners. The outside basis is increased by $10 under Sec. 705 from the subpart F inclusion in year 1 and by $10 of tax-exempt income realized by DP in year 2, and is reduced by $10 of nondeductible, noncapitalizable expenditures in year 2, netting an increase of $10. This result is consistent with the goal of Sec. 705 to maintain equality of the outside and inside bases.
Basis Adjustments in Cases of CFC Stock Held by a Foreign Partnership
Example 2: Assume the same facts as Example 1, except that Foreign Partnership (FP) holds the CFC stock.
Unlike DP in Example 1, FP is not a U.S. person or a U.S. shareholder. Under Sec. 958(a)(2), US1 and US2 are treated as owning the CFC stock in proportion to their FP interests. Therefore, in year 1, FP does not have a subpart F inclusion, and US1 and US2 do not increase their outside basis under Sec. 705. Instead, under Secs. 951(b) and 958(a)(2), US1 and US2 are considered the U.S. shareholders of CFC and therefore are required to have a subpart F inclusion of $5 each in year 1. US1 and US2 increase their outside basis in FP by the subpart F inclusions, or $5 each, under Sec. 961(a) because US1's and US2's FP interest is the property by which they are considered to own the CFC stock. FP is not entitled to an increase in its inside basis in the CFC stock because it is not a U.S. shareholder and no amount has been included in its gross income with respect to CFC's subpart F income.
When CFC distributes $10 in year 2, the corresponding earnings were not previously taxed. FP, therefore, arguably recognizes dividend income, which should be stated separately under Sec. 702(a). The outside basis of US1 and US2 is increased by their distributive shares of the dividend income, or $5 each. US1 and US2, however, should exclude the dividend from income under Sec. 959(a) because they have previously included in income CFC's subpart F income, similar to corporate partners' ability to take into account dividends-received deductions in respect of their distributive shares of corporate dividends received by the partnership (Regs. Sec. 1.702-1(a)(5)). However, the outside basis of US1 and US2, previously increased by their subpart F inclusions, is reduced by the PTI distribution under Sec. 961(b).
To summarize, US1's and US2's outside basis totals $10 at the end of year 1 and is increased by $10 for their distributive shares of FP's dividend income and reduced by $10 for the PTI distribution in year 2, netting a total outside basis of $10 at the end of year 2.
Note that no statutory or regulatory provision increases FP's inside basis in the CFC stock for the subpart F inclusions by US1 and US2 in year 1. Without such a basis increase, FP would recognize gain (or reduced loss) from the sale of the CFC stock before the PTI is distributed to FP.
Congress addressed this issue for cases in which, in a tiered CFC structure, the lower-tier CFC generates income giving rise to the U.S. shareholders' subpart F inclusion, by enacting Sec. 961(c) in 1997. Sec. 961(c) permits an increase to the top-tier CFC's basis in the lower-tier CFC, but only for limited purposes.
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 202-414-1048 or email@example.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.