Foreign taxes on PTEP can provide additional foreign tax credits

Editor: Mark Heroux, J.D.

As the world eagerly awaits the issuance of regulations addressing previously taxed earnings and profits (PTEP) by Treasury and the IRS,this third installment of the authors’ ongoing series covering international earnings and profits (E&P) rules focuses on the potential increase in the Sec. 904(a) foreign tax credit limitation when PTEP is distributed by a controlled foreign corporation (CFC) to its corporate “U.S. shareholder.” A U.S. shareholder who is an individual and has made a Sec. 962 election may also be eligible to increase his or her Sec. 904 foreign tax credit limitation in this scenario.

Simplified example

In two previous articles (Alajbegu and Brown, “Tax Clinic: Foreign Income Taxes Deemed Paid and the PTEP Rules,” 51 The Tax Adviser 633 (October 2020) and “Tax Clinic: Demystifying the New International E&P Rules,” 50 The Tax Adviser 690 (October 2019), the authors explained the application of the U.S. international PTEP rules by way of modifying an example contained in the applicable Treasury regulations (Regs. Sec. 1.960-3(e), Example (1)). As illustrated in the diagram, “Distribution From CFC to USP” (below), a domestic corporation (USP) owns all of the stock of CFC and therefore is the U.S. shareholder in this example. Both entities have calendar year ends, and one unit of CFC’s functional currency “u” is equal to $1 at all relevant times. In year 1, USP has 1,000u Subpart F income and 500u of global intangible low-taxed income (GILTI) inclusion from CFC. Assume that USP does not have any Sec. 965(a) or Sec. 965(b) PTEP related to CFC and that CFC’s year 1 income giving rise to the Subpart F and GILTI inclusions is not subject to foreign tax. Also assume that the Subpart F inclusion is allocated and apportioned to the Sec. 951(a)(1)(A) PTEP group in the passive category and the GILTI inclusion is Sec. 951A PTEP in the 951A category. Finally, in year 2, CFC makes a Sec. 959(a) PTEP distribution of the 1,500u to USP, and the distribution suffers 450u of foreign withholding taxes.

As detailed in the authors’ previous article, after the distribution, CFC has no PTEP. Further, because CFC had PTEP groups in more than one Sec. 904 category in the same year and did not have any Sec. 965(a) or Sec. 965(b) PTEP, it is anticipated the forthcoming PTEP regulations will provide that the distribution would be made pro rata out of the E&P in each Sec. 904 category. (See Alajbegu and Brown, “Tax Clinic: Demystifying the New International E&P Rules,” 50 The Tax Adviser 690 (October 2019)). The example has been simplified by assuming that CFC distributes the entire amount of its PTEP.

Finally, the PTEP group tax rules are applied separately to each category (i.e., the distribution is applied separately to CFC’s Sec. 951(a)(1)(A) PTEP in the passive category and its Sec. 951A PTEP in the 951A category)). As such, USP’s proportionate share of PTEP group taxes with respect to CFC’s year 1 passive category Sec. 951(a)(1)(A) PTEP group is $300, and its proportionate share of PTEP group taxes related to year 1 951A category Sec. 951 PTEP group is $150. USP is deemed to have paid taxes on these amounts with respect to the Sec. 959(a) PTEP distribution. This assumes the taxes were not already deemed paid in the current or any prior tax year. Additionally, according to the Joint Committee on Taxation, General Explanation of Public Law 115-97 (JCS-1-18) (Dec. 20, 2018), p. 393 (i.e., the Blue Book), a technical correction may be needed to enact the position that only 80% of foreign income taxes paid or accrued (or treated as paid or accrued) with respect to distributions out of GILTI PTEP are creditable under Sec. 901.

Distribution of PTEP to US shareholders

At this point, one might wonder what is the point in categorizing and tracking CFC’s PTEP and related PTEP group taxes as they are paid up the chain from CFC to USP. The answer can be found in Sec. 960(c), which generally increases a U.S. shareholder’s Sec. 904 foreign tax credit limitation for the year of receipt of a PTEP distribution from a CFC.

To highlight the applicability of this taxpayer-favorable provision, recall that PTEP is not included in taxable income again when distributed by a CFC to a U.S. shareholder. This may occur, for example, if the PTEP distribution is made during a tax year in which the CFC did not generate income that gives rise to a Subpart F or GILTI inclusion for the U.S. shareholder. As such, U.S. shareholders of CFCs with PTEP may not have sufficient foreign-source income for the tax year of a PTEP distribution to use additional taxes deemed paid (the foreign withholding taxes applied to the distribution of PTEP from CFC to USP in our example) as foreign tax credits under the general rules of Secs. 901 and 960. However, when applicable, Sec. 960(c) can increase the Sec. 904 limitation by the lesser of: (1) taxes paid, deemed paid, or accrued with respect to distributions of Subpart F or GILTI PTEP or (2) the so-called excess limitation amount for each Sec. 904 category. Broadly, the excess limitation amount is the amount by which the Sec. 904 limitation was increased by reason of a Subpart F and/or GILTI inclusion in gross income for the inclusion year and decreased by any foreign income taxes allowed as a credit for the inclusion year that were allowable solely by reason of such Subpart F and/or GILTI inclusion.

Returning to the example, assume that USP does not have any E&P attributable to a Subpart F or GILTI inclusion in year 2 (i.e., the year CFC makes a Sec. 959(a) PTEP distribution of 1,500u to USP). Also assume that USP generates U.S.-source taxable income and claims a foreign tax credit under Sec. 901. In this scenario, because USP had a Subpart F and GILTI inclusion in year 1 (i.e., prior to the tax year of the PTEP distribution), Sec. 960(c) may allow USP to increase the Sec. 904 limitation applicable to the Sec. 951(a)(1)(A) PTEP group by $300 and applicable to the 951A PTEP group by $150 if these amounts are less than or equal to the excess limitation amount.

A continuing journey

This journey through the international E&P rules has taken readers from the PTEP ordering rules of Notice 2019-1 through the PTEP group tax rules of Regs. Sec. 1.960-3 and now into the potential increase of foreign tax credit limitation from the distribution of PTEP. During the journey, the authors have striven to clearly explain these rules through examples based on those found in the relevant Treasury regulations. The authors look forward to continuing this journey with an update on the international E&P rules when regulations are issued by Treasury and the IRS.

EditorNotes

Mark Heroux, J.D., is a tax principal in 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.