'Toll charge' guidance may trigger capital gain on PTI distributions

By Adam G. Province, J.D., LL.M., Washington

While providing new guidance largely helpful to taxpayers, recent IRS notices have brought to the fore an issue that has been latent for many years, creating potential uncertainties regarding the consequences of a midyear distribution of previously taxed income (PTI) by a controlled foreign corporation (CFC).

Background

Sec. 961(a) provides for an increase in a U.S. shareholder's basis in its CFC stock as a result of a Subpart F income inclusion under Sec. 951(a). Sec. 961(b)(1) provides for a reduction of a U.S. shareholder's CFC stock basis as a result of PTI distributions from the CFC. Under Sec. 961(b)(2), to the extent that a PTI distribution from a CFC exceeds the U.S. shareholder's CFC stock basis, the U.S. shareholder recognizes gain.

Sec. 961 is silent on when these basis adjustments are made. Under Regs. Secs. 1.961-1(a)(1) and 1.961-2(a)(1), basis increases are made "as of the last day in the taxable year of such corporation on which it is a [CFC]" and basis is reduced by distributions of PTI "as of the time [the U.S. shareholder] receives such excluded amount," respectively. These timing rules create an issue when PTI is distributed before the end of the year of the income inclusion, because they technically deem the reduction to occur before the increase — and if the shareholder does not happen to have sufficient preexisting basis in its CFC stock, the result could be gain recognition under Sec. 961(b)(2) (and perhaps also an artificial built-in loss created in the CFC stock at year end).

When faced with this issue, many taxpayers have concluded that, notwithstanding the general timing rules provided in the regulations, the basis decrease resulting from a midyear PTI distribution should take the corresponding basis increase into account (and no gain recognition should occur under Sec. 961(b)(2) for U.S. shareholders who otherwise have insufficient basis) because the contrary result — namely, double taxation of the same earnings — would be inappropriate.

Tax reform legislation

As amended by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, Sec. 965(a) generally subjects to tax a U.S. shareholder's pro rata share of the accumulated post-1986 deferred foreign income (DFI) of a specified foreign corporation (SFC), such as a CFC. As a result of the income inclusion, the U.S. shareholder's basis in the SFC stock would be increased under Sec. 961(a), any DFI subject to Sec. 965(a) would become PTI, and the distribution of this PTI would result in a stock basis decrease under Sec. 961(b).

In addition, Sec. 965(b)(1) generally allows a U.S. shareholder to reduce its Sec. 965 inclusion by any aggregate foreign earnings and profits (E&P) deficit amount from the U.S. shareholder's E&P deficit foreign corporations (i.e., SFCs that have deficits in their post-1986 E&P). Under Sec. 965(b)(4), an amount equal to the U.S. shareholder's reduction under Sec. 965(b)(1) that is allocated to a deferred foreign income corporation (DFIC) is treated as an amount that was included in the gross income of that U.S. shareholder under Sec. 951(a). Consequently, Sec. 965(b)(4)(A) indicates that any E&P offset by a deficit as a result of Sec. 965(b)(1) is treated as PTI.

The statute does not expressly provide for a corresponding basis adjustment under Sec. 961(a) for amounts included under Sec. 965(b)(4)(A). Instead, Sec. 965(o)(1) grants Treasury authority to issue "regulations or other guidance to provide appropriate basis adjustments." In this regard, the TCJA conference report includes the following suggestions: "For example, with respect to the stock of the [DFIC], the Secretary may determine that a basis increase is appropriate in the taxable year of the section 951A inclusion or, alternatively, the Secretary may modify the application of section 961(b)(1) with respect to such stock" (H.R. Conf. Rep't No. 115-466, 115th Cong., 1st Sess. 620-21 (Dec. 15, 2017)).

Notice 2018-07

On Dec. 29, 2017, Treasury and the IRS issued Notice 2018-07, announcing their intention to issue regulations for determining amounts included in gross income by a U.S. shareholder under Sec. 951(a)(1) by reason of Sec. 965. Section 3.03 of the notice states that the regulations will provide that if a U.S. shareholder receives distributions from a DFIC during the inclusion year that are attributable to PTI by reason of Sec. 965(a), the amount of gain recognized by the U.S. shareholder on the DFIC stock under Sec. 961(b)(2) will be reduced (but not below zero) by a Sec. 965(a) inclusion amount (the "gain-reduction rule").

Notice 2018-13

On Jan. 19, 2018, Treasury and the IRS issued Notice 2018-13, clarifying certain aspects of Notice 2018-07, particularly the application of the gain-reduction rule described in Section 3.03 of Notice 2018-07. Section 4 of Notice 2018-13 states that Treasury and the IRS intend to issue regulations that will provide that the gain-reduction rule announced in Notice 2018-07 also applies to distributions received from a DFIC through a chain of ownership described in Sec. 958(a) (i.e., direct and indirect stock ownership held by a U.S. shareholder). Under Notice 2018-13, these regulations will provide that if a U.S. shareholder receives distributions through such a chain of ownership from a DFIC during the inclusion year "that are attributable to" PTI by reason of Sec. 965(a), the amount of gain recognized under Sec. 961(b)(2) by the U.S. shareholder on the stock or property of any entity in the ownership chain through which the distribution is made will be reduced (but not below zero) by the Sec. 965(a) inclusion amount of the U.S. shareholder with respect to the DFIC.

Section 4 of Notice 2018-13 also provides that under the regulations, the gain-reduction rule will apply to reduce the amount of gain that otherwise would be recognized under Sec. 961(c) by any CFC in the ownership chain through which the distribution is made to a U.S. shareholder for purposes of determining the amount included under Sec. 951(a)(1) in the U.S. shareholder's gross income.

Section 6 of Notice 2018-13 states that until the regulations are issued, "taxpayers may rely on the rules described in sections 3 and 4" of this notice.

The issue

By providing relief from gain recognition under Sec. 961(b)(2) as a result of midyear distributions of PTI attributable to Sec. 965(a) inclusions, the notices call into question the historic position of many taxpayers that gain is not to be recognized under Sec. 961(b)(2) upon a midyear distribution of PTI attributable to current-year Sec. 951(a) inclusions. Moreover, because the notices expressly provide relief from the timing mismatch under Regs. Secs. 1.961-1(a)(1) and 1.961-2(a)(1) only for PTI attributable to Sec. 965(a) inclusions, it is unclear whether the gain-reduction rule applies to PTI resulting from the application of Sec. 965(b)(4)(A).

Concerns of ordering and basis adjustments

Assuming for the sake of argument that the gain-reduction rule applies only to distributions of PTI attributable to Sec. 965(a) inclusions, taxpayers then need to determine whether a particular distribution is attributable to that PTI or attributable to other PTI (such as Sec. 965(b)(4) PTI or ordinary Subpart F PTI), or both (perhaps under a pro rata approach). Whatever the approach, the results under the gain-reduction rule likely would be affected.

This problem is illustrated by the following example.

Example: A U.S. shareholder (DP) wholly owns a CFC (FC1), a DFIC for purposes of Sec. 965, and has an adjusted basis of $0 in FC1 stock at the beginning of 2017. On Oct. 1, 2017, FC1 makes a $10 distribution to DP and also earns $5 of Subpart F income. At the end of 2017, DP has a Sec. 965(a) inclusion amount of $20 in relation to FC1's DFI measured on Dec. 31, 2017.

Under Regs. Sec. 1.961-1(a)(1), DP's tax basis in FC1's stock may not be increased by the Sec. 965(a) inclusion and the Subpart F income inclusion until Dec. 31, 2017. Without additional guidance, DP's tax basis in FC1's stock would be zero on Oct. 1, causing a $10 gain on the distribution.

The ordering of PTI as a result of the Sec. 965(a) and Subpart F inclusions in relation to the Oct. 1 distribution also is unclear. Assuming the PTI resulting from the $20 Sec. 965(a) inclusion applies first, then the gain-reduction rule would apply to DP's entire $10 distribution, leaving no taxable gain. If, however, the Oct. 1 distribution is deemed to be paid first out of the PTI from the $5 Subpart F inclusion, then the gain-reduction rule would not reduce the entire $10 distribution, resulting in $5 of taxable gain. Alternatively, if the two types of PTI are deemed to be paid out pro rata (i.e., 5/25, or 20%, out of Subpart F PTI and 20/25, or 80%, out of Sec. 965(a) PTI), then the result would be $2 of taxable gain.

Clarifying guidance necessary

Without further clarification, distributions from CFCs may be deemed to require U.S. shareholders to recognize gain under Sec. 961(b)(2). Ideally, fixing the basis-mismatch rule in the current regulations would resolve permanently any confusion on whether gain would result from midyear PTI distributions. Even if Treasury and the IRS cannot resolve the basis-mismatch rule, they should provide additional guidance for clarifying the ordering and basis adjustments related to all types of PTI distributions.

EditorNotes

Annette B. 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 annette.smith@pwc.com.

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

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