Shortly after Congress added Subpart F to the Internal Revenue Code (IRC or “the Code”) in 1962 to tax U.S. shareholders of controlled foreign corporations (CFCs) on their deemed proportionate share of foreign income, the IRS released its first regulations on previously taxed earnings and profits (PTEP) to protect against double taxation of that income. In the decades since, the guidance in this area of the tax law has lagged significantly behind the changes brought on by the enactment of Tax Cuts and Jobs Act (TCJA). As a result, taxpayers and their advisors have been forced to rely on limited guidance such as IRS Notice 2019-01 and IRS Notice 2024-16.
With the release of proposed regulations (REG-105479-18), Treasury and the IRS have begun to formalize some of the practices that have become commonplace in this area over the years and to address questions raised by the addition of the Global Intangible Low-Taxed Income (GILTI) provisions and other changes in the TCJA. The proposed regulations provide rules for PTEP accounting (both at the shareholder level and the foreign corporation level), exclusions from gross income, and related determinations and adjustments to stock basis.
Tracking PTEP and taxes at the shareholder and CFC level; enhancements to Notice 2019-01
Previous systems have tracked PTEP primarily at both the shareholder and CFC level. The proposed regulations address basis adjustments when a covered shareholder owns a foreign corporation through a partnership and when the partnership disposes of its shares in the foreign corporation. A partnership has derived basis in a derivative ownership unit, which is maintained separately with respect to each covered shareholder that owns the derivative ownership unit through one or more partnerships.
This new proposed approach ensures that, in structures involving multiple covered shareholders, foreign income taxes that are associated with PTEP are tracked to each particular covered shareholder and don’t include foreign income taxes imposed on PTEP with respect to another covered shareholder. Thus, in a distribution of PTEP to a covered shareholder, the covered shareholder’s basis will be reduced by the foreign income taxes that are:
- Associated with (and consequently reduced) PTEP with respect to the covered shareholder.
- Deemed paid by the covered shareholder.
This method is intended to prevent each covered shareholder from incurring double taxation on a single item of income by ensuring that covered shareholders can account for the specific foreign income taxes that generated their allocable PTEP.
The end result of the changes is a slightly more elaborate version of the annual PTEP accounts that were created coming out of IRS 2019-01. The proposed rules create a PTEP accounting system that includes annual PTEP accounts, dollar-basis pools, and PTEP tax pools. These concepts are similar to existing rules, but some of the processes governing the calculations have changed.
Section 961 adjustments to CFC stock basis
The proposed regs under Section 961 adjust the basis in shares of stock of a foreign corporation owned by a covered shareholder, as well as the basis in any items of property through which the covered shareholder owns stock of the foreign corporation, to reflect the foreign corporation’s PTEP with respect to that covered shareholder. For example, basis would be adjusted to reflect income inclusions giving rise to the PTEP or distributions of the PTEP. Unlike annual PTEP accounts, basis adjustments under the proposed regulations would be specific and tacked onto each share of stock or another item of property, consistent with each item of property having a separate distinct tax basis under the code.
Guidance confirms PTEP types and midyear GILTI treatment
The proposed regs confirm the classification of PTEP described in Notice 2019-01 into 10 different types and the last-in, first-out (LIFO) approach for affected distributions. They also confirm timing of and the midyear concept for distributions in which current year GILTI and Subpart F income are generated and deemed earned at the beginning of the PTEP year. The clarification is welcomed as it confirms previous administrative guidance described in Advice Memo 2023-02 and addresses an issue that could occur in situations where a distribution comes out of earnings and profits and creates a midyear taxable gain.
Proposed guidance always leaves doors open to changes and future proposals
Anytime Treasury and IRS release proposed regulations on a section of the Tax Code that has been without clarifying guidance for some time, it’s certain that a host of affected taxpayers and stakeholders will provide comments that could affect the final product.
One unusual aspect of these proposed regulations is that they would apply to taxable years beginning on or after the date once the regulations become finalized. In most cases, guidance like this often comes with language that taxpayers can rely on the proposals in the interim until the final regulations are released at a future date, but these regulations take a different approach. Instead, once finalized, a taxpayer may choose to apply these regulations but must do so consistently to all preceding years. The ability to apply to preceding years may require adjustments to calculations and amended returns.
Due to the complexities around partnership basis and the differing types of PTEP between the partnership and the partner level, further clarifications and guidance would be welcomed. Additionally, left unresolved in the current draft of the regulations is what happens when an upper-tier CFC sells a lower-tier CFC and the income is treated as Subpart F to the U.S. shareholder under 964(e). It’s still unclear whether PTEP and basis are generated at the first-tier CFC and how that would be addressed in the transaction.
The proposed regulations were released by the IRS and Treasury in December 2024 with a request for comments within a 90-day window. Treasury, as anticipated, has received a great deal of commentary addressing further concerns and where the proposed regulations may still fall short of providing clarifications. In response, Treasury has extended the comment period through July 2025. Since then, other priorities, including a broader tax bill, have taken center stage, and the timeline for releasing the final rules has become murky at best. If finalization is delayed, taxpayers may face uncertainty on how to apply the proposed rules and continue to wait for future guidance on unresolved areas.
