Taxpayers have been eagerly awaiting, and the US Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) have been promising to provide, rules addressing the previously taxed earnings and profits (PTEP) of foreign corporations. On November 30, 2024, the Treasury and the IRS made good on their promise. The proposed PTEP regulations are generally welcome news for taxpayers seeking certainty about long-standing issues, including the treatment of mid-year distributions, Section 961(c) basis, and partnerships that hold foreign corporations. However, those welcome developments come at the cost of substantial complexity and several taxpayer-unfavorable provisions. In this On the Subject, we provide a brief overview of PTEP and why it matters and share five key takeaways from the proposed regulations.

In Depth

OVERVIEW OF PTEP

The PTEP rules provide that when earnings of a foreign corporation have been included in the US shareholder’s gross income, when those earnings are distributed, they are excluded under Section 959(a) from the US shareholder’s gross income to ensure the same earnings are not subject to US taxation twice. Under Section 959(b), PTEP distributions from a lower-tier controlled foreign corporation (CFC) to an upper-tier CFC are also excluded from the upper-tier CFC’s income for purposes of determining the upper-tier CFC’s gross income. The Section 961 rules provide for adjustments in the US shareholder’s basis in CFC stock to prevent taxpayers from obtaining a loss when the stock is sold before PTEP is distributed. Under Section 961(a), Subpart F and global intangible low-taxed income (GILTI) inclusions increase the US shareholder’s basis in the CFC. Under Section 961(b), distributions decrease it. Section 961(c) provides that similar adjustments are made to an upper-tier CFC’s basis in a lower-tier CFC but only for purposes of determining the amount included under Section 951 in the gross income of a US shareholder.

The PTEP rules have become much more important to US-based multinationals since the Tax Cuts and Jobs Act of 2017 (TCJA) vastly increased the amount of foreign corporations’ earnings subject to current US taxation as GILTI. Post-TCJA, some shareholders may even prefer a distribution of untaxed earnings and profits, which may qualify for the Section 245A dividends received deduction and does not require a Section 961(b) reduction in basis.

The current Section 959 PTEP regulations are from 1965 and do not address many key issues. In 2006, the Treasury and the IRS issued proposed PTEP regulations, but the proposed regulations did not expressly permit taxpayer reliance, and the rules were withdrawn in 2020.

The newly proposed rules are complex, but here are five key takeaways to keep in mind:

1. They Are Generally Prospectively Effective and Cannot Be Relied Upon Now (But Can Be Relied on Retroactively if and When the Rules Are Finalized).

Most of the regulations will be effective for taxable years ending on or after the date the regulations are finalized.

Taxpayers are not allowed to rely on the proposed regulations prior to them being finalized. The Treasury has indicated that they did not allow taxpayers to rely on the regulations while in proposed form because of the complexity of the rules and the fact that they introduce new concepts not previewed in prior guidance. The regulations may also be changed before finalization after considering taxpayer comments. However, once the rules are finalized, taxpayers will be able to elect to apply them retroactively to any open tax years as long as they apply all of the proposed rules in full and are consistent about applying the rules to related corporations.

The rules include transition rules to bridge years for which the regulations are effective with prior years.

2. They Require Shareholder and Foreign-Corporation-Level Accounting.

The proposed PTEP rules are quite complex in that they require PTEP to be tracked at both the US shareholder and the foreign corporation level. In addition to PTEP, shareholders must track (1) a US dollar basis pool, which is their US dollar basis in the original PTEP inclusion for purposes of recognizing foreign exchange gain or loss under Section 986(c), and (2) a PTEP tax pool, which is the US dollar basis of foreign income tax pools associated with the US dollar basis pool.

The proposed rules largely follow the ordering rules set forth in Notice 2019-01, which was released in late 2018. These rules generally require that 10 different PTEP groups be tracked within each Section 904(d) foreign tax credit category on an annual basis. To slightly simplify compliance, taxpayers may elect to combine years within a PTEP group and Section 904(d) foreign tax credit category, rather than tracking each year separately.

These ordering rules include a rule to treat Section 965(a) and Section 965(b) PTEP, which resulted from the one-time transition tax as part of the TCJA, as being distributed first before other types of PTEP (even PTEP earned in a more recent tax year). The rule was aimed at reducing complexity by allowing Section 965 PTEP to come out first so corporations and the IRS would not have to track Section 965 PTEP groups in perpetuity.

The proposed PTEP regulations set forth rules for when adjustments to PTEP and associated stock basis are made. One key rule is that increases to PTEP for GILTI or Subpart F inclusions are done at the beginning of the year, so PTEP (and the associated stock basis) is available for mid-year distributions.

3. They Adopt a Share-by-Share Approach to Section 961 Basis

The proposed regulations provide that, unlike PTEP accounts, section 961 basis is specific to particular shares or items of property, such as partnership interests. The timing of basis adjustments is intended to generally match the timing of adjustments to PTEP accounts. The share-by-share approach to section 961 basis differs from the proposed regulations’ approach to section 959, which does not tie particular dollar basis pools of PTEP to particular shares held by a US shareholder. In certain cases, this mismatch could give rise to a shareholder recognizing gain on some shares even though the shareholder has unrecovered basis on other shares, a result arguably inconsistent with the repatriation-facilitating goal of the TCJA. Taxpayers should consider whether they have “lumpy” basis in CFC stock that could give rise to such a mismatch. Post-TCJA, a distribution of PTEP (historically a good attribute) may be less favorable in certain circumstances than a distribution of untaxed earnings and profits that qualifies for the Section 245A dividends received deduction and generally does not require a reduction in basis.

4. They Provide Detailed Rules for Lower-Tier Basis

In addition to providing rules for Section 961(a) basis, the proposed regulations also provide rules for lower-tier basis, including both (1) “derived basis” (a new term applicable to shares or partnership interests owned by a partnership and distinct from the partnership’s common basis in such shares or partnership interests), and (2) Section 961(c) basis (applicable to shares of a lower-tier CFC owned by an upper-tier CFC). The proposed regulations provide that both derived basis and Section 961(c) basis can be negative. Derived basis can be negative to the extent of common basis; amounts exceeding the common basis are recognized as gain. Taxpayers should be careful to track Section 961(c) basis – yet another separate type of basis or account to track – to ensure that “negative” Section 961(c) basis is not inadvertently triggered as gain, which can even occur in connection with transactions that are otherwise nonrecognition transactions.

5. They Don’t Address Certain Key Items

As expected, the proposed regulations do not address certain key items, such as whether/how PTEP transfers from one shareholder to another in Section 304 transactions, redemptions, and most nonrecognition transactions, such as 351 transactions and liquidations. The Treasury and the IRS plan to address those issues in a second tranche of PTEP guidance. The proposed regulations also do not address what happens to Section 961(c) basis when an upper-tier CFC inbounds to the United States (e.g., whether the Section 961(c) basis can be used as “regular” basis), which Notice 2024-16 permits in the case of “covered inbound transactions.”

CONCLUSION

The proposed PTEP regulations cover a lot of ground. The Treasury and the IRS have requested comments on several provisions and encourage taxpayers to provide comments on whether the proposed regulations get it right. Taxpayers should study the rules carefully and consider whether there are provisions worth asking the Treasury and the IRS to reconsider.