On December 14, 2018, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued guidance (Notice 2019-01 or the Notice) describing proposed regulations that they intend to issue addressing certain issues arising from the enactment of the Tax Cuts and Jobs Act (P.L. 115-97) with respect to foreign corporations with previously taxed earnings and profits (PTEP) and announcing their intent to withdraw the 2006 proposed regulations relating to the exclusion of PTEP from gross income.

These forthcoming regulations will provide (i) rules relating to the maintenance of PTEP in annual accounts and within certain groups, (ii) rules relating to the ordering of PTEP upon distribution and reclassification, and (iii) rules providing an adjustment to PTEP accounts when an income inclusion exceeds the earnings and profits (E&P) of a foreign corporation.

Background

PTEP refers to the E&P of a foreign corporation attributable to amounts that are or have been included in the gross income of a US shareholder under section 951(a) or section 1248(a). After the Tax Cuts and Jobs Act, PTEP (or E&P treated the same as PTEP) may arise from, inter alia, inclusions of subpart F income, inclusions resulting from certain investments in United States property, inclusions of global intangible low-taxed income (GILTI), inclusions resulting from the transition tax under section 965(a), and E&P offset by deficits for purposes of the transition tax pursuant to section 965(b). Distributions of PTEP are excluded under section 959(a) from a US shareholder’s gross income or the gross income of any other US person who acquires the US shareholder’s interest in the foreign corporation. Similarly, under section 959(b), when PTEP is distributed through a chain of controlled foreign corporations (CFCs) owned by a US shareholder entitled to exclude the PTEP under section 959(a), the PTEP is excluded from the receiving CFC’s gross income for purposes of determining the subpart F income of such CFC.

Distributions from a foreign corporation are first attributable to the PTEP described in section 959(c)(1) (related to inclusions resulting from investments in United States property or E&P that would have been included as a result of such investments were the E&P not already PTEP), then to PTEP described in section 959(c)(2) (all other PTEP), and finally to E&P described in section 959(c)(3) (untaxed E&P).
Following the Tax Cuts and Jobs Act, the exclusion of distributions of PTEP from a US shareholder’s gross income is less significant than it was under prior law, because distributions of untaxed E&P from a 10%-owned foreign corporation will in most cases be eligible for the 100% dividends received deduction under section 245A. However, PTEP distributions have consequences that do not apply to distributions of untaxed E&P, including deemed payment of related foreign taxes, recognition of foreign currency gain or loss, and reduction in the US shareholder’s basis in the stock of the distributing foreign corporation. Accordingly, the determination of whether, and which, PTEP is distributed to a US shareholder continues to have significant ramifications.

Notice 2019-01

In Notice 2019-01, Treasury and the IRS announced that forthcoming regulations will provide that US shareholders and CFCs will be required to maintain annual PTEP accounts segregated into 16 PTEP groups within each section 904 category, based on the provision under which the E&P was originally classified as PTEP. Of the 16 PTEP groups, nine relate to section 959(c)(1) PTEP (including section 959(c)(2) PTEP that has been reclassified as section 959(c)(1) PTEP), and seven relate to section 959(c)(2) PTEP. Once E&P becomes PTEP, it remains in the annual PTEP account related to the year in which it became PTEP, even if it is later reclassified or distributed to another foreign corporation.

Notice 2019-01 further states that for purposes of measuring the foreign currency gain or loss recognized on a distribution of PTEP, the forthcoming regulations will provide that the dollar basis must be tracked for each annual PTEP account and separately for each PTEP group within an annual account. Transition rules will be provided allowing for the conversion of historic PTEP pools that combined years or types of PTEP and used an average dollar basis to treat each such pool as a PTEP group in a single PTEP annual account for the last taxable year ending before the applicability date of the proposed regulations. However, PTEP related to section 965 cannot be combined with other PTEP under such transition rules.

Recently proposed regulations addressing foreign taxes deemed paid with respect to PTEP distributions also establish a system of accounting for PTEP in annual accounts for each separate section 904 category and further separate each annual account among 10 PTEP groups (which represent a subset of the 16 PTEP groups described in the Notice). The Notice indicates that the rules in the final foreign tax credit regulations will be coordinated with the forthcoming PTEP regulations as appropriate.

The Notice states that the forthcoming regulations will incorporate the ordering rules of section 316 to provide a general “last-in, first-out” (LIFO) approach to the sourcing of distributions from PTEP described in sections 959(c)(1) and (c)(2), respectively, except that PTEP related to section 965 will be prioritized. Thus, subject to the section 965 PTEP prioritization exception, section 959(c)(1) PTEP in the most recent annual PTEP account will be distributed first, followed by the succeeding most recent annual section 959(c)(1) PTEP account. The distribution from each annual PTEP account will be treated as coming pro rata out of each of the section 959(c)(1) groups not related to section 965. After the section 959(c)(1) PTEP has been exhausted, the same approach, subject to the same section 965 PTEP prioritization exception, will apply to section 959(c)(2) PTEP. The Notice indicates that corresponding PTEP accounts in separate section 904 categories will be aggregated for purposes of applying the ordering rules, with distributions treated as made pro rata out of the PTEP in each section 904 category.

As noted above, the Notice prioritizes PTEP attributable to income inclusions resulting from section 965(a) and to E&P offset by deficits under section 965(b). Under this rule, distributions will be sourced first from section 959(c)(1) PTEP related to reclassified PTEP attributable to section 965(a) inclusions and then to section 959(c)(1) PTEP related to reclassified PTEP attributable to section 965(b). Thereafter, a distribution is sourced from the remaining section 959(c)(1) PTEP groups, pro rata and in accordance with LIFO. When all of the section 959(c)(1) PTEP are exhausted, distributions will then be sourced from section 959(c)(2) PTEP related to section 965(a) and, once exhausted, section 965(b). Similarly, further distributions are sourced from the remaining section 959(c)(2) PTEP groups pro rata and in accordance with LIFO. Finally, once all of the PTEP groups have been exhausted, the remaining amount of any distributions will be sourced from section 959(c)(3) E&P (non-PTEP), to the extent thereof.

The Notice states that the regulations will confirm that distributions from any PTEP group to a US shareholder reduce the shareholder’s stock basis without regard to how such basis was created. Further, the Notice indicates that based on the section 959 reference to the general dividend definition contained in section 316, the forthcoming regulations will clarify that PTEP is only treated as distributed to the extent a distribution of untaxed E&P would have otherwise been a dividend under section 316. Accordingly, if a foreign corporation has a deficit or zero current and accumulated E&P at the end of its taxable year, a distribution will be a return of basis or treated as gain from the sale or exchange of stock, regardless of whether the shareholder has an annual PTEP account with respect to its stock in the distributing foreign corporation.

Finally, the Notice provides that the forthcoming regulations under section 959 will provide rules to accommodate the fact that the GILTI and transition tax provisions provide for income inclusions that create PTEP that may exceed the foreign corporation’s E&P. The forthcoming regulations will provide adjustments to permit the creation of PTEP while ensuring that the foreign corporation’s net E&P is equal to its aggregate PTEP and section 959(c)(3) E&P. In such a scenario, current-year E&P is first classified as section 959(c)(3) E&P and then section 959(c)(3) E&P is reclassified as section 959(c)(1) PTEP or section 959(c)(2) PTEP, as appropriate, in full. This may have the effect of creating or increasing a deficit in section 959(c)(3) E&P. For example, where a US shareholder’s inclusion under section 951(a) by reason of section 965(a) exceeds current E&P of the CFC, section 959(c)(3) E&P will first be increased by the CFC’s current E&P and then decreased by the entire amount of the CFC’s section 965 inclusion, possibly below zero. The applicable PTEP will be increased by the same amount. Where a foreign corporation has a current-year deficit in E&P, that deficit will only reduce the foreign corporation’s section 959(c)(3) E&P without affecting the amount of its section 959(c)(1) PTEP or section 959(c)(2) PTEP.

The Notice provides that the forthcoming regulations will apply to taxable years of US shareholders ending after December 14, 2018, and to taxable years of foreign corporations ending with or within such taxable years. A taxpayer generally can rely on Notice 2019-01 before the issuance of regulations if the taxpayer and all related parties (under section 267(b) or section 707(b)) apply the rules consistently with respect to the PTEP of all foreign corporations in which the taxpayer or related party owns stock, beginning with the taxpayer’s or related party’s (as relevant) section 965 inclusion year.

Treasury and the IRS have acknowledged the complexity and compliance challenges associated with the maintenance of numerous PTEP groups within annual PTEP accounts. The Notice requests comments on ways to simplify the PTEP accounts required to be maintained while balancing the need for precision in applying the foreign tax credit and foreign currency gain or loss rules. Comments on this and other potential guidance related to PTEP are requested by February 12, 2019.

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