The proposed PTEP rules: Tax basis considerations under Sec. 961

The IRS and Treasury on Nov. 29, 2024, released proposed regulations (REG-105479-18) addressing previously taxed earnings and profits (PTEP) of foreign corporations. The proposed regulations provide considerable guidance on key PTEP provisions, including the maintenance and tracking of PTEP accounts, shareholder basis adjustments, the determination of U.S. shareholders’ pro rata share of Sec. 951(a) inclusions, the treatment of consolidated groups and partnerships, foreign currency gain/loss rules under Sec. 986(c), and rules for individual U.S. shareholders of controlled foreign corporations (CFCs) who make Sec. 962 elections.

This article focuses on the Sec. 961 basis adjustment considerations included in the proposed PTEP regulations.

Generally, the proposed regulations are set to apply to tax years of foreign corporations beginning on or after the final regulations are published in the Federal Register. However, some provisions previously addressed in Notice 2019-1 will apply retroactively to tax years ending after Dec. 14, 2018. Taxpayers can elect to apply the proposed regulations (once finalized) to earlier tax years, subject to a consistency requirement.

Legislative background

Sec. 959 and the related PTEP regulations are designed to prevent double taxation of distributions of a CFC’s earnings that were previously taxed to U.S. shareholders under antideferral regimes such as Subpart F (Sec. 951(a) and Sec. 956), global intangible low-taxed income (GILTI) (Sec. 951A), and the transition tax (Sec. 965(a)).

Sec. 961(a) aids in preventing double taxation by allowing an increase in a U.S. shareholder’s basis in the shares of stock of a foreign corporation (as well as the basis in any items of property through which the U.S. shareholder owns stock of a foreign corporation) for the previously taxed amounts deemed included in the U.S. shareholder’s gross income under Sec. 951(a), with respect to that foreign corporation. This increase in basis protects the shareholder from recognizing gain on the sale of such shares of stock, or property, to the extent of its share of undistributed PTEP within the CFC. For purposes of Sec. 961, Sec. 951A(f)(1) allows similar basis increases to result from a U.S. shareholder’s GILTI inclusion from a CFC.

Sec. 961(b)(1) authorizes a corresponding reduction in a U.S. shareholder’s basis in stock of a foreign corporation (or of any items of property through which the U.S. shareholder owns stock of a foreign corporation), for distributions of PTEP excluded from the U.S. shareholder’s gross income under Sec. 959, thus preventing the taxpayer from receiving double benefits from previous basis increases. Further, to the extent that a distribution exceeds the U.S. shareholder’s basis in stock of a foreign company (or of any items of property through which the U.S. shareholder owns stock of a foreign corporation), Sec. 961(b)(2) treats such excess as gain from the sale or exchange of property.

Sec. 961(c) dictates similar adjustments to apply to U.S. shareholders’ basis in stock of CFCs indirectly owned through other CFCs and allows for basis increases or decreases for the intermediary CFCs’ stock, but only for purposes of determining the amount included under Sec. 951. Sec. 961(c) also includes rules for successor U.S. shareholders that grant carryover Sec. 961(c) basis attributes to a U.S. shareholder that acquires stock of a CFC from another U.S. shareholder.

While Regs. Sec. 1.965-2(f)(1) generally provides that basis is not increased under Sec. 961 to reflect PTEP resulting from Sec. 965(b), Regs. Sec. 1.965-2(f)(2) permits taxpayers to elect to make certain basis adjustments.

Basis considerations in the proposed PTEP regulations

The proposed regulations would amend the rules under Sec. 961 to include provisions for specific types of shareholders, distinct types of property with corresponding basis, and a multistep approach to basis adjustments.

The proposed Sec. 961 regulations differentiate the type of basis of an item of property, based on whether the direct owner of the item is a “covered shareholder,” a partnership, or a CFC.

A covered shareholder is defined as any U.S. person other than a domestic partnership (Prop. Regs. Sec. 1.959-1(b)) and is not limited to the Sec. 951 definition of a U.S. shareholder (because the exclusion under Sec. 959(a) is not limited to U.S. shareholders). Under Sec. 959(a), any U.S. person that acquires an interest (that carries PTEP attributes) in a foreign corporation is therefore granted the benefits of such PTEP attributes.

These distinctions regarding direct owners are necessary because a domestic partnership is treated as an aggregate of its partners under Regs. Sec. 1.958-1(d)(1) in determining stock ownership for purposes of Sec. 961. When a U.S. shareholder holds a CFC interest indirectly through a partnership or another CFC, the benefits of basis should reflect that specific shareholder’s inclusions and should be a benefit only for that specific shareholder (a “covered shareholder-specific basis” in the proposed regulations’ preamble). In addition, Sec. 961(c) limits the application of the basis provisions for interests in CFCs owned indirectly through other CFCs to determining the amount of inclusions in the gross income of a U.S. shareholder under Sec. 951. For this purpose, the rules apply similarly to S corporations.

Under the proposed Sec. 961 regulations, the basis in shares of stock of a foreign corporation owned by a covered shareholder and the basis in any items of property through which the covered shareholder owns stock of the foreign corporation are adjusted to reflect the foreign corporation’s PTEP with respect to the covered shareholder (to reflect increases from income inclusions giving rise to the PTEP or decreases following distributions of PTEP). Basis adjustments under the proposed regulations are specific to a share of stock or other item of property and are maintained in U.S. dollars to ensure consistency between basis increases and reductions, despite movements in exchange rates. The proposed regulations also include Sec. 986(c) rules for recognizing foreign currency gain or loss on such movements.

Property units

Three types of property (“property units”) and basis are introduced under the Sec. 961 proposed regulations:

• Sec. 961(a) ownership units and adjusted basis, in relation to a covered shareholder;
• Derivative ownership units and derived basis, with respect to a partnership (these are covered-shareholder-specific); and
• Sec. 961(c) ownership units and Sec. 961(c) basis, applicable to a CFC (also covered-shareholder-specific) (see the diagram, “Ownership Units and Basis Example”).

Ownership units and basis example

The diagram helps visualize the differences between Secs. 961(a), 961(b), and 961(c) types of ownership units and basis. USC is a U.S. corporation and a covered shareholder. USP is a U.S. partnership in which USC has a 30% interest. USP wholly owns the shares of CFC1, and CFC1 wholly owns the shares of CFC2. USC wholly owns the shares of CFC3. The green arrows depict USC’s Sec. 961(a) ownership units and USC’s basis in USP and USC’s Sec. 961(a) ownership units and USC’s basis in the 10 shares of CFC3, respectively. The red dotted arrow depicts USC’s derivative ownership units and USP’s derived basis in USP’s 30 shares of CFC1. The blue dotted arrow depicts USP’s Sec. 961(c) ownership units and CFC1′s basis in three shares of CFC2 attributable to USC.

A Sec. 961(a) ownership unit is defined as a share of stock of a foreign corporation directly owned by a covered shareholder, or a partnership interest directly owned by a covered shareholder and through which the covered shareholder owns stock of a foreign corporation (Prop. Regs. Sec. 1.961-2(c)). The covered shareholder adjusts the Sec. 961(a) basis of property units it owns.

Prop. Regs. Sec. 1.961-2(d)(1) defines a derivative ownership unit as a share of stock of a foreign corporation directly owned by a partnership and owned (indirectly) by one or more covered shareholders through only one or more partnerships (i.e., not through a foreign corporation), or a partnership interest directly owned by another partnership and through which one or more covered shareholders own stock of a foreign corporation only through partnerships. The partnership has derived basis in a derivative ownership unit and must maintain this basis separately with respect to each covered shareholder that owns the respective derivative ownership units. Unlike typical basis, derived basis with respect to a covered shareholder may be a positive or negative amount and is treated as an attribute of the partnership that directly owns the derivative ownership unit, with no effect on the partnership’s adjusted basis in the shares of the CFC (“common” basis shared among all partners) or any other asset of the partnership.

Lastly, under Prop. Regs. Sec. 1.961-2(e)(1), a Sec. 961(c) ownership unit is a share of stock of a foreign corporation directly owned by a CFC and owned (indirectly) by one or more covered shareholders. An upper-tier CFC has Sec. 961(c) basis in a Sec. 961(c) ownership unit, and that basis must be established and maintained separately with respect to each covered shareholder that owns the Sec. 961(c) ownership unit(s). Like derived basis, Sec. 961(c) basis may be a positive or negative amount and is treated as an attribute of the CFC that directly owns the Sec. 961(c) ownership unit, which affects only the gain or loss on the disposition of the Sec. 961(c) ownership unit, with otherwise no effect on the CFC’s adjusted basis in the Sec. 961(c) ownership unit, other assets of the CFC, its gross income, or earnings and profits (E&P). Sec. 961(c) basis applies only for the limited purposes prescribed in the existing Sec. 961 regulations.

Basis adjustments

The proposed regulations provide basis increase rules for property units that are shares of stock of CFCs owned by a covered shareholder and for property units through which the covered shareholder owns such stock, to reflect a covered shareholder’s income inclusions under Secs. 951(a) and 951A (i.e., the shareholder’s pro rata share of the CFC’s Subpart F and GILTI inclusions for the tax year). Under these rules, basis increases begin at the level of stock of the CFC and then tier up through the property units through which the covered shareholder owns the stock, increasing basis among property units based on how PTEP is, or likely will be, subsequently distributed on each of the property units (distinguishing and trying to mirror, for example, the PTEP basis increases for a preferred-share-of-stock property unit vs. a common-stock property unit, based on how distributions with respect to such shares will later occur).

Basis increases are generally treated as occurring at the beginning of the first day of the CFC’s tax year or, if later, the first day in the tax year on which the covered shareholder owns the property unit. However, increases due to a Sec. 951(a)(1)(B) inclusion are treated as made at the end of the last day of the tax year (subject to a further exception for property units transferred before the end of the tax year). The timing of the basis increase is also subject to special rules in the case of midyear transactions (i.e., any sale, exchange, or other disposition occurring before the last relevant day of the tax year that changes the covered shareholder’s ownership structure of the CFC).

The regulations outline a four-step process to determine basis increases (Prop. Regs. Sec. 1.961-3(c)):

1. Determine the amount of income inclusions giving rise to increases in basis;
2. Determine if any midyear transactions occurred;
3. Apply the actual-distribution rule (i.e., for actual distributions during the tax year, determine how those distributions are assigned to each share of stock of the CFC and how income inclusions would thus be assigned); and
4. Apply the hypothetical-distribution rule (for any remaining undistributed PTEP resulting from current-year inclusions).

Under the proposed Sec. 961 regulations, basis reductions are mandated for PTEP distributions excluded from covered shareholders’ gross income and for the portion of foreign income taxes attributable to PTEP received and for which the covered shareholder is allowed a foreign tax credit under Sec. 901. Further, the regulations require gain to be recognized if such distributions exceed the basis of the property units to which the distributions are assigned.

These rules describe the amounts of adjustments, limitations on basis reductions, and treatment of gain under Sec. 961, which can differ depending on the type of property unit for which the basis is being adjusted.

Basis-shifting from one property unit (i.e., share of stock) to another is not permitted, which can result in gain recognition with respect to some, but not other property units of the same shareholder, with respect to different shares of stock of the same CFC.

More complex rules apply for covered shareholders with derived basis through a partnership or Sec. 961(c) basis through a CFC. For derivative ownership units, Sec. 743(b) and Sec. 705 adjustments are imposed when the distribution exceeds derived basis (which can create negative derived basis, subject to a limitation). If the amount of the adjustment exceeds the available derived or Sec. 961(c) basis, the partnership or CFC holding the property unit is treated as recognizing gain from a sale or exchange of the derivative ownership or Sec. 961(c) ownership unit, respectively. Such gain is allocated solely to the covered shareholder of the property unit, without having any impact on the partnership’s computations or allocations of any other items under Sec. 703 or Sec. 704 or on the covered shareholder’s capital account, or on the CFC’s E&P or tested income.

Negative derived basis and negative Sec. 961(c) basis (relevant only for Sec. 951 transactions) can result from basis reductions. The proposed regulations also limit negative basis reductions to the extent of the partnership’s common basis or the CFC’s adjusted basis available for the covered shareholder.

The regulations provide further guidance on various other basis topics, including adjustments for foreign currency gain or loss, transfers in general successor transactions, adjustments for deemed dividends under Sec. 1248 or Sec. 964(e)(1), tax consequences of positive derived and Sec. 961(c) basis, gain recognition in transactions involving property units with negative basis, and U.S. shareholder gain recognition for negative Sec. 961(c) basis.

Clarifications, but with complexity

While the proposed regulations bring welcome clarifications to the timing of the basis adjustments and allow basis increases for both U.S. shareholders and the intermediate holders of shares of a CFC’s stock, they also add significant complexity to basis tracking, especially in tiered partnership structures.

Despite their complexity, the regulations recognize that additional guidance is still needed for various other topics and situations. The IRS requested comments from the general public and advises taxpayers and tax professionals that it intends to issue additional rules regarding a number of key PTEP concepts.

— Alexis Brewer, J.D., LL.M., is an international tax associate in Dallas; Ioana Lacatusu, CPA, MBA, is a managing director, international tax in Dallas; Jerry Seade, J.D., LL.M., is a partner, international tax services in Houston; and Michael Masciangelo, CPA, MST, is tax principal, international tax in Houston, all with BDO USA. To comment on this article or to suggest an idea for another article, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.