The U.S. Department of Treasury (Treasury) recently released proposed regulations under §§ 959 and 961 and related Code sections (REG-105479-18, the “Proposed Regulations”) addressing the treatment of previously taxed earnings and profits (“PTEP”) of foreign corporations.  The Proposed Regulations establish complicated mechanical rules for the tracking of PTEP and § 961 basis, both at the shareholder and corporate level. The Proposed Regulations also provide that § 961 basis, unlike § 959 annual PTEP accounts which are shareholder specific, is determined with respect to a specific share or block of stock.¹

Changes in the Proposed Regulations create not only additional administrative burdens for taxpayers, but also can result in gain recognition on a distribution even if there is sufficient total basis in all of the CFC’s stock to cover the distribution.  This approachcreates the potential for gain recognition where it would not necessarily be expected.  Below is a brief summary of selected interesting issues in the Proposed Regulations.²

     1. There is no basis sharing among consolidated group members for PTEP distributions.

The Proposed Regulations provide that a U.S. consolidated group is treated as a single covered shareholder for purposes of § 959, however require each consolidated group member to compute and take into account its own items with respect to the stock of foreign corporations, including the tax consequences of a distribution from a CFC and as a result § 961(a) basis adjustments are made separately with respect to each consolidated group member’s actual ownership interests in CFCs.³ This can result in gain even where the group would otherwise have sufficient basis in the CFC’s stock to absorb the gain. Consider the following example adapted from Prop. Reg. § 1.1502-59(f)(5). 

Example. U.S. Parent owns 100% of domestic subsidiaries USS1 and USS2 who file a consolidated return for U.S. tax purposes.  USS1 and USS2 own all the shares of a single class of stock of foreign subsidiary F1, with USS1 owning 60 shares and USS2 owning 40 shares. F1 makes a pro rata covered distribution to USS1 and USS2 out of PTEP in the amount of $6x per share (including any creditable foreign taxes imposed on the distribution).  Immediately before the distribution USS1’s adjusted basis of each share of F1 stock is $8x and USS2’s is $5x. USS1 and USS2 separately reduce adjusted basis in each share of F1 stock, with USS1 reducing its basis in each share to $2x ($8x original basis minus a $6x adjustment per share) and USS2 recognizes $1x of gain per share ($5x original basis minus a $6x adjustment results in $1x of gain recognized).  

     2. Non-§ 961 basis is still relevant in determining gain.

If a covered shareholder receives a PTEP distribution from a CFC, then the covered shareholder’s § 961 basis in the CFC is reduced by the amount of the distribution (and any associated creditable foreign income taxes). The covered shareholder recognizes gain to the extent that the reduction exceeds § 961 basis (or in the case of § 961(c) basis, where basis is limited in its ability to go below zero, as discussed below). Prop. Reg. § 1.961-4(f) treats this gain as gain from the sale or exchange of the shares occurring concurrent with the basis adjustment.

Example. U.S. Parent owns CFC and has $10x in § 961(a) basis and $50x in non-§ 961(a) basis in CFC.  CFC has $30x in PTEP and makes a $30x distribution to U.S. Parent in excess of its $10x § 961(a) basis in CFC.  Under Prop. Regs. §§ 1.961‑4(b)(2)(iii) and 1.961-4(f)(1), a covered shareholder is treated as recognizing gain from a sale or exchange of the § 961(a) ownership unit to the extent the required reduction to the adjusted basis of a § 961(a) ownership unit exceeds its adjusted basis. As a result, U.S. Parent first reduces its § 961(a) basis in CFC from $10x to $0 then, as a result of the sale or exchange treatment, recovers the remaining $20x from its $50x non‑§ 961(c) basis in CFC as a result of the distribution.

     3. § 961(c) Basis Can Go Negative

Section 961(c) provides separate basis adjustment rules (separate from the basis increase and decrease rules in §§ 961(a) and (b)) for “§ 961(c) ownership units,” which generally are lower-tier CFCs. Basis is adjusted and maintained separately for each covered shareholder of a § 961(c) ownership unit similar to the §§ 961(a) and 961(b) rules, with one key distinction: § 961(c) basis may go negative. For example, if an upper-tier CFC receives a PTEP distribution excluded from gross income under § 959(b), then § 961(c) basis is adjusted for each covered shareholder on a share-by-share basis and reduced by the amount of the distribution (and any associated creditable foreign taxes), including below zero. An adjustment to § 961(c) basis can reduce basis below zero (and thus not result in immediate gain) only to the extent, when tested against a “limitation” established under the regulations, the basis reduction does not decrease basis beyond the established limitation amount.⁴ The limitation amount compares a covered shareholder’s share of non-§ 961(c) basis of a § 961(c) ownership unit (reduced by any negative § 961(c) basis in the CFC) against the proposed amount of basis decrease below zero for that covered shareholder. Negative basis (to the extent allowed) does not create immediate § 961(c) gain but must be recognized when a CFC’s basis is relevant in determining taxable income in a transaction, such as a “covered gain” transaction (a sale, exchange, or disposition of the § 961(c) ownership unit). Section 961(c)’s negative basis rules allow taxpayers to avoid reducing non-§ 961(c) basis on a PTEP distribution in excess of § 961 basis. Consider the following example adapted from the proposed regulations in Prop. Reg. § 1.1502-59(f)(6). 

Example. U.S. Parent owns all the shares of domestic subsidiaries USS1 and USS2. USS1 and USS2 directly own all the shares of foreign subsidiary, F1, with USS1 owning 60 shares and USS2 owning 40 shares. F1 owns all shares of foreign subsidiary F2. F2 then makes a covered distribution (i.e., a dividend) to F1, when PTEP and associated creditable foreign income taxes on the distribution with respect to each share of F2 stock is $6x. Immediately before the covered distribution, F1’s adjusted (non-§ 961(c)) basis in each share of F2 stock is $3x and its § 961(c) basis with respect to each share is $5x ($8x total basis). 

Under Prop. Reg. § 1.961-4(d), F1 reduces its § 961(c) basis in each share of F2 stock on which it receives PTEP, made separately with respect to USS1 and USS2. USS1’s portion of F1’s § 961(c) basis is $3x (60% of the $5x of § 961(c) basis), which is reduced by its share of PTEP and creditable foreign income taxes on the distribution in the amount of $3.60x (60% of the $6x in PTEP and creditable foreign taxes imposed on the PTEP distribution). The reduction to USS1’s § 961(c) basis exceeds the positive § 961(c) basis prior to the distribution of $3x, so must be tested against the limitation. The amount of non-§ 961(c) basis in each share available to USS1 is $1.80x (60% of F1’s adjusted non-§ 961(c) basis of $3x in each share of F2), which is greater than the reduction of USS1’s § 961(c) basis below zero of $0.60x, thus USS1’s § 961(c) basis can go below zero and no gain is recognized. USS2’s portion of F1’s § 961(c) basis is $2x (40% of the $5x § 961(c) basis), which is reduced by its share of PTEP and foreign taxes of $2.4x (40% of the $6x in PTEP and creditable foreign taxes imposed on the PTEP distribution). The limitation amount for USS2 is $1.2x (40% of F1’s adjusted non-§ 961(c) basis of $3x in each share of F2) which exceeds $0.4x thus USS2’s § 961(c) basis can also go negative. The separately computed § 961(c) bases are then recombined and F1’s § 961(c) basis becomes negative $1x. 

¹  Prop. Reg. § 1.961-3(b).

²  A full explanation of the PTEP rules under §§ 959 and 961 is beyond the scope of this article.

³  The preamble to the Proposed Regulations states that sharing basis would “create opportunities for inappropriate tax planning by shifting basis among members in a way that does not reflect the economics of the members’ investments.”   

⁴  Prop. Reg. § 1.961-4(d)(3).