Foreign income taxes deemed paid and the PTEP rules

Editor: Mark Heroux, J.D.

Practitioners continue to navigate through the complexities of U.S. international tax rules created by the law known as the Tax Cuts and Job Act (TCJA), P.L. 115-97. While further IRS guidance is awaited as of this writing, Treasury and the IRS issued a set of final and temporary regulations in December 2019 that include rules for determining foreign income taxes deemed paid under Sec. 960, which pertains to the “deemed paid” foreign tax credit (T.D. 9882).

In a previous article, the authors focused on Notice 2019-1, which concerns the exclusion from gross income of previously taxed earnings and profits (PTEP) (Alajbegu and Brown, “Tax Clinic: Demystifying the New International E&P Rules,” 50 The Tax Adviser 690 (October 2019)). There is an overlap between that topic and the present one.

A provision of the new Sec. 960 regulations, Regs. Sec. 1.960-3(c), requires a controlled foreign corporation (CFC) to establish separate annual PTEP accounts for amounts attributable to Subpart F and global intangible low-taxed income (GILTI) inclusions of their U.S. shareholders (as defined in Sec. 951(b)). The Sec. 960 regulations also provide rules for accounting for foreign income taxes deemed paid under Sec. 960(b)(1) (by a domestic corporation with respect to a distribution of Sec. 959(a) PTEP from a CFC) and Sec. 960(b)(2) (by a CFC with respect to a distribution of Sec. 959(b) PTEP from a lower-tier CFC).

Similar to the PTEP accounts in Notice 2019-1, each PTEP account in Regs. Sec. 1.960-3(c) must correspond to the inclusion year of the PTEP and to the Sec. 904 category to which the Subpart F and GILTI inclusions are assigned at the U.S. shareholder level. Both the notice and the foreign tax credit regulations require the amount in each PTEP account to be further assigned to one or more groups of PTEP.

It is clear that Treasury and the IRS are making a concerted effort to coordinate the PTEP rules in Regs. Sec. 1.960-3(c) with those that will be contained in future PTEP guidance described in Notice 2019-1, which announced the IRS’s intent to issue PTEP regulations. As such, in what would be welcome relief, it is noted that the preamble to the Sec. 960 regulations provides that certain PTEP groups listed in Notice 2019-1 have been consolidated, reducing the total number of PTEP groups from 16 to 10.

As one would expect, the Sec. 960 regulations also provide rules that CFCs must follow to account for the foreign income taxes paid or accrued or deemed paid with respect to the amount in each PTEP group. PTEP group taxes are the U.S. dollar sum of:

• Current-year taxes paid or accrued by a CFC that are properly allocated and apportioned to the PTEP group; and
• Foreign income taxes deemed paid under Sec. 960(b)(2) by a CFC with respect to a distribution of PTEP under Sec. 959(b) received from a lower-tier CFC added to the appropriate PTEP group.

Pursuant to Sec. 960(b)(2), when a lower-tier CFC distributes Sec. 959(b) PTEP to an upper-tier CFC, the upper-tier CFC will be deemed to have paid the lower-tier CFC’s foreign income taxes properly attributable to the Sec. 959(b) PTEP (assuming such taxes were not already deemed paid in the current or any prior tax year). CFCs will be required to reduce PTEP group taxes for:

• Foreign income taxes deemed paid under Sec. 960(b)(2) by an upper-tier CFC that received a Sec. 959(b) PTEP distribution from the CFC; and
• Foreign income taxes deemed paid under Sec. 960(b)(1) by a corporate U.S. shareholder of the CFC that received a Sec. 959(a) PTEP distribution from the CFC.

Sec. 960(b)(1) applies to distributions by a CFC to its corporate U.S. shareholder and broadly provides that foreign income taxes properly attributable to Sec. 959(a) PTEP are deemed to have been paid by the U.S. shareholder (assuming such taxes were not already deemed paid in the current or any prior tax year). PTEP group taxes will also need to be adjusted — either up or down — in the case of a reclassified PTEP group of the CFC.

As complex as the foreign income tax accounting rules applicable to PTEP group taxes summarized above seem, Example 1 of Regs. Sec. 1.960-3(e) provides a helpful illustration of some of the mechanics of the rules. The following is a simplified version of Example 1:

USP, a domestic corporation, owns all of the stock of CFC1, which in turn owns all of the stock of CFC2. All three entities have calendar year ends for tax purposes, and any foreign currency exchange fluctuations are eliminated as one unit of the CFCs’ functional currency “u” is equal to $1 at all relevant times. In year 1, USP has a 1,000u Subpart F income inclusion related to CFC2. CFC2 allocates and apportions the Subpart F income to the year 1 Sec. 951(a)(1)(A) PTEP group in the passive category (assume CFC2 has no earnings and profits (E&P) other than 1,000u of PTEP resulting from USP’s year 1 Subpart F inclusion). In year 2, CFC2 makes a Sec. 959(b) PTEP distribution of the 1,000u to CFC1, and the distribution suffers 300u of withholding taxes.

An analysis of Example 1 logically adds the 1,000u Sec. 959(b) PTEP distribution from CFC2 to CFC1 in CFC1′s year 1 annual PTEP group in the passive category as Sec. 951(a)(1)(A) PTEP. CFC1′s passive category Sec. 951(a)(1)(A) PTEP group is then reduced by the 300u of withholding tax. Similarly, CFC2′s year 1 passive category Sec. 951(a)(1)(A) PTEP group is reduced by the 1,000u distribution to CFC1. Finally, the 300u of withholding tax is translated into U.S. dollars, and $300 is added to the PTEP group taxes in CFC1′s year 1 Sec. 951(a)(1)(A) PTEP group within the passive category. When the dust settles, CFC2 has no PTEP and no PTEP group taxes; and CFC1 has 700u in its year 1 passive category Sec. 951(a)(1)(A) PTEP group and $300 PTEP group taxes in the same PTEP group and category.

Conclusion

The journey under the new international E&P rules continues and takes practitioners from the PTEP ordering rules of Notice 2019-1 to the PTEP group tax rules in the Sec. 960 regulations. Thankfully, Treasury and the IRS have simplified the journey by reducing the number of PTEP groups. Practitioners can expect the two sets of rules to be further coordinated in future guidance.

EditorNotes

Mark Heroux, J.D., is a tax principal and leader of the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago.

For additional information about these items, contact Mr. Heroux at 312-729-8005 or mark.heroux@bakertilly.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly US, LLP.