In proposed regulations published 2 December 2024 (REG-105479-18; Proposed Regulations), the United States (US) Department of Treasury (Treasury) and the Internal Revenue Service (IRS) addressed PTEP of foreign corporations and related basis adjustments under IRC Sections 959 and 961 and related statutory provisions. The Proposed Regulations cover core aspects of the PTEP system, including PTEP accounting, basis adjustments, and related provisions, and address longstanding questions and new complexities introduced by the Tax Cuts and Jobs Act of 2017 (TCJA). Treasury and the IRS intend to cover certain issues not covered in the Proposed Regulations, including nonrecognition transactions, redemptions, IRC Section 964(e) transactions, and controlled foreign corporations (CFCs) as partners in a partnership, in future guidance.

The Proposed Regulations would generally apply to foreign corporations' tax years beginning on or after the date they are finalized (except for certain provisions under IRC Section 959 relating to Notice 2019-01, 2019-02 IRB 275 (2019 Notice), which would apply retroactively to tax years ending after 14 December 2018). Taxpayers may apply the Proposed Regulations earlier subject to certain requirements.

Comments on the Proposed Regulations are due by 3 March 2025.

Detailed discussion

I. Background

The Proposed Regulations aim to address PTEP complexities resulting from the enactment of the TCJA and other statutory changes (including the enactment of IRC Sections 961(c) and 986(c)) and update existing regulations under IRC Sections 959 and 961, which were initially promulgated in 1965. The PTEP regulations were originally designed to prevent double taxation on foreign corporation earnings and profits (E&P) that had already been subjected to US tax as subpart F income. IRC Section 961 works together with IRC Section 959, providing corresponding basis adjustments to prevent both double taxation and inappropriate tax benefits by ensuring that the basis of a US shareholder's stock in a foreign corporation is adjusted to reflect IRC Section 951(a) inclusions and PTEP distributions.

The TCJA significantly increased the types and amounts of income that give rise to PTEP, including global intangible low-taxed income (GILTI) under IRC Section 951A(a), accumulated post-1986 untaxed E&P under IRC Section 965, and certain hybrid dividends under IRC Section 245A(e). Additionally, the TCJA introduced IRC Section 245A, which interacts with the PTEP rules and allows a domestic corporation to claim a dividends-received deduction for certain non-PTEP earnings.

Several aspects of the Proposed Regulations were previously addressed by the 2019 Notice, including the maintenance of PTEP accounts, PTEP ordering, and other topics under IRC Sections 959 and 961 arising from the TCJA. Further, in Notice 88-71, 1988-2 CB 374 (1988 Notice), Treasury and the IRS provided guidance on the application of IRC Section 986(c), a provision enacted in the Tax Reform Act of 1986 that requires recognizing foreign currency gain or loss on PTEP distributions due to exchange rate movements between the deemed income inclusion date and the PTEP distribution date. The Proposed Regulations would implement aspects of those Notices and introduce additional rules on the treatment of PTEP in non-wholly owned structures, domestic partnerships, and consolidated groups.

II. Core PTEP framework

A. PTEP accounting structure under IRC Section 959

Under IRC Section 959, E&P of a foreign corporation previously included in a US shareholder's gross income under IRC Section 951(a) is generally not included again when distributed to the US shareholder or certain successors.

1. Shareholder annual PTEP accounts and corporate PTEP accounts

The Proposed Regulations under IRC Section 959 would establish a two-level system for PTEP accounting — one at the shareholder level and the other at the foreign corporation level. PTEP tracking is important for several purposes, including (1) determining foreign currency gain or loss under IRC Section 986(c); (2) allocating that gain or loss to foreign tax credit categories under IRC Section 904; and (3) determining and allocating deemed paid foreign tax credits under IRC Section 960(b).

The shareholder-level accounting system would require covered shareholders to create and maintain annual PTEP accounts, dollar basis pools, and PTEP tax pools for the foreign corporations in which they directly or indirectly own stock. For this purpose, a covered shareholder means any US person, other than a domestic partnership or a S corporation (which is treated as a domestic partnership for purposes of IRC Section 959 regulations).

Annual PTEP accounts would track a foreign corporation's PTEP, which would be distributable exclusively to the covered shareholder (directly or indirectly). Each annual PTEP account would concern a single tax year of the foreign corporation and a single IRC Section 904 category. An account would be maintained in the foreign corporation's functional currency among 10 PTEP groups and two subgroups. The 10 PTEP groups would be divided into IRC Section 959(c)(2) PTEP groups and IRC Section 959(c)(1) PTEP groups: the former would separately track PTEP arising by reason of subpart F income inclusions, GILTI inclusions, IRC Section 965(a) or 965(b), and inclusions to which IRC Section 245A(d) applies. The latter represents PTEP from a US shareholder's IRC Section 956 inclusions and amounts initially classified in the IRC Section 959(c)(2) PTEP groups but reclassified under IRC Section 959(a)(2) by reason of excluding from gross income a US shareholder's otherwise includible IRC Section 956 amount. The two subgroups would track PTEP resulting from income inclusions of certain covered shareholders (i.e., individuals making an IRC Section 962 election on the one hand and individuals, estates, and trusts including net investment income under IRC Section 1411(c) on the other). The Proposed Regulations would additionally require the covered shareholder to maintain, for PTEP resulting from the application of IRC Section 965(a) or IRC Section 965(b), an adjusted applicable percentage (the percentage of a disallowed credit or deduction for foreign income taxes associated with PTEP under Treas. Reg. Section 1.965-5) and an IRC Section 965(c) deduction percentage (the percentage of non-recognized foreign currency gain or loss for PTEP under Treas. Reg. Section 1.986(c)-1).

Together with annual PTEP accounts, the covered shareholder would be required to maintain dollar basis pools and PTEP tax pools. Dollar basis pools represent the basis in US dollars of a foreign corporation's PTEP for purposes of determining foreign currency gain or loss under IRC Section 986(c). PTEP tax pools would track the US dollar amount of foreign income taxes associated with a foreign corporation's PTEP with respect to a covered shareholder for purposes of determining foreign income taxes eligible to be deemed paid under IRC Section 960(b). While dollar basis pools and PTEP tax pools would generally be maintained annually, with one pool by each PTEP group within each annual PTEP account, covered shareholders could elect to combine these pools across years for each PTEP group within each IRC Section 904 category. The election would apply to all of the foreign corporations in which the covered shareholder owns stock and could be revoked only with IRS consent.

At the level of the foreign corporation, corporate PTEP accounts would be established for each covered shareholder and each IRC Section 904 category. Generally, corporate-level PTEP accounts would facilitate the allocation and apportionment of foreign taxes paid on PTEP (e.g., by reason of PTEP distributions) and the application of IRC Section 956. The foreign corporation's corporate PTEP tax pools would also be tracked for each covered shareholder and for each IRC Section 904 category. Similar to corporate PTEP accounts, corporate PTEP tax pools would encompass all foreign income taxes within the covered shareholder's PTEP tax pools for the foreign corporation.

Under successor rules, PTEP accounts and the associated US dollar basis and PTEP tax pools could be transferred to another covered shareholder in a "general successor transaction," which is defined as a covered shareholder's acquisition of ownership of foreign corporation stock that, immediately before the transaction, is owned by another covered shareholder. However, several commonplace transactions in which CFC stock is transferred would not be treated as general successor transactions, including any portion of an acquisition of ownership of foreign corporation stock that results from (1) an issuance of stock or a partnership interest, (2) a redemption of stock (within the meaning of IRC Section 317(b)) or a liquidating distribution in redemption of a partnership interest, or (3) a transfer of stock of a foreign corporation, or any property through which a foreign corporation stock is owned, if such stock or property were substituted basis property.

The successor rules would apply not only when a covered shareholder transfers foreign corporation stock to another covered shareholder, but also when a covered shareholder transfers foreign corporation stock to a foreign person, which in turn transfers that stock to another covered shareholder. In those transactions, the foreign person would be treated as a "deemed covered shareholder," and the ultimate covered shareholder transferee would be required to reconstruct the PTEP accounts and related consequences during the deemed covered shareholder's ownership period. The deemed covered shareholder rules could significantly increase the administrative burdens of these regulations, particularly in the context of mergers and acquisitions.

2. Shareholder account adjustments

The Proposed Regulations would require a covered shareholder to adjust its annual PTEP accounts, dollar basis pools, and PTEP tax pools for a foreign corporation at one of three points in time: (1) at the beginning of the foreign corporation's tax year, (2) concurrently with certain transactions, or (3) at the end of the foreign corporation's tax year. In each case, corresponding adjustments to the dollar basis pools and PTEP tax pools would be made concurrently with the relevant adjustments to annual PTEP accounts.

At the beginning of the foreign corporation's tax year, three types of PTEP would be added to annual PTEP accounts: (1) PTEP from the covered shareholder's subpart F and GILTI inclusions with respect to the foreign corporation for the year, (2) PTEP distributed to the foreign corporation during the year, and (3) PTEP resulting from the application of positive IRC Section 961(c) basis to reduce gain recognized by the foreign corporation during the year. Distributions of current-year PTEP often would not result in gain under IRC Section 961(b)(2), as PTEP account increases and corresponding IRC Section 961 basis increases attributable to a subpart F income or GILTI inclusion generally occur at the beginning of the year (even though the inclusion itself occurs at the end of the year).

Three types of adjustments would occur at the same time as a related transaction: (1) PTEP distributed by the foreign corporation during the year would be removed from annual PTEP accounts concurrently with the distribution, (2) IRC Section 959(e) PTEP from gain treated as a dividend under IRC Section 1248(a) or (f) would be added to annual PTEP accounts at the time of the stock disposition, and (3) PTEP would be removed from or added to annual PTEP accounts by reason of general successor transactions at the time of the transaction.

Lastly, at the end of the foreign corporation's tax year, two types of adjustments would occur: (1) PTEP to which the IRC Section 956 amount is allocated would be reassigned from IRC Section 959(c)(2) PTEP groups to IRC Section 959(c)(1) PTEP groups, and (2) PTEP relating to the portion of the IRC Section 956 amount included in gross income of the covered shareholder would be added to annual PTEP accounts.

3. Ordering and composition rules

Consistent with the 2019 Notice, the Proposed Regulations would generally require distributions of PTEP to be sourced from IRC Section 959(c)(1) PTEP groups first, followed by IRC Section 959(c)(2) PTEP groups. The PTEP within each such group would be sourced on a "last-in, first-out" (LIFO) basis, subject to an exception (the IRC Section 965 priority rule); under the exception, PTEP in IRC Section 959(c)(1) PTEP groups would be sourced first from the reclassified IRC Section 965(a) PTEP group, then from the reclassified IRC Section 965(b) PTEP group, and lastly from the remaining IRC Section 959(c)(1) PTEP groups. Likewise, PTEP in IRC Section 959(c)(2) PTEP groups would be sourced first from the IRC Section 965(a) PTEP group, then from the IRC Section 965(b) PTEP group, and finally from the remaining IRC Section 959(c)(2) PTEP groups. Rejecting comments that IRC Section 965 PTEP should be subject to the statute's general LIFO approach, Treasury and the IRS justified the IRC Section 965 priority rule by stating that the approach would eliminate IRC Section 965 PTEP eventually, thereby reducing administrative burdens and the number of PTEP groups that need to be tracked.

4. Exclusions

Under the IRC Section 959(a) exclusion, PTEP distributed to a covered shareholder, other than taxable IRC Section 962 PTEP, is excluded from the covered shareholder's gross income. Under the IRC Section 959(b) exclusion, PTEP distributed by a foreign corporation to a CFC is excluded from the recipient CFC's gross income for purposes of determining the recipient CFC's subpart F income and tested income or tested loss, provided that the PTEP relates to a covered shareholder that is a United States shareholder in both the recipient CFC and the distributing corporation.

To implement those exclusions, the Proposed Regulations would source a distribution from PTEP to the extent that there is a balance in the covered shareholder's PTEP accounts with respect to the foreign corporation. A covered shareholder would maintain those accounts with respect to a foreign corporation rather than with respect to particular stock; accordingly, PTEP could arise by reason of an inclusion on one share of stock but be distributed with respect to a different share of stock. As discussed later, while the regulations would require PTEP sharing across shares (and in some circumstances across covered shareholders), basis sharing under IRC Section 961 would not be permitted. This disconnect could cause the recognition of excess gains.

B. IRC Section 951(a) pro rata share rules

The Proposed Regulations would significantly alter the implications of PTEP for determining subpart F income in structures with split ownership. To avoid partial double taxation for US shareholders, Revenue Ruling 82-16 applied a "gross-up" mechanism, in which IRC Section 959(b) applied to all of the E&P of the lower-tier CFC that caused the subpart F income inclusion, not just the PTEP attributable to the relevant US shareholder.

The Proposed Regulations would eliminate the gross-up mechanism and instead coordinate the IRC Section 959(b) exclusion and the IRC Section 961(c) exclusion with the pro-rata share rules of IRC Section 951(a), ensuring that the exclusions are specific to the US shareholder to which the PTEP and PTEP basis relates. Specifically, the Proposed Regulations would introduce two new coordinated sets of rules for determining a US shareholder's pro rata share of a foreign corporation's covered items: covered distributions (generally, dividends distributed by a foreign corporation) and covered gain (generally, gain recognized by a CFC on a share of foreign corporation stock).

At the level of the foreign corporation, the Proposed Regulations would first assign covered items to each covered shareholder based on their stock ownership on the last relevant day (defined later) of the foreign corporation's tax year (with special rules for general successor transactions). A general assignment rule would assign a pro-rata portion of covered items to each covered shareholder, based on a fraction (where the numerator is generally the hypothetical distribution based on the covered shareholder's ownership in the CFC, and the denominator the total hypothetical distribution). For example, US1 and US2 each own 50% of F1, which owns F2 and F3. For F1's tax year ending December 31, F1 has £500x of earnings and two covered items (a £60x distribution from F2 and a £40x gain from F3). US1 and US2 are each assigned £30x of the distribution (£60x × £250x/£500x) and £20x of the gain (£40x × £250x/£500x).¹

At the shareholder level, the CFC's subpart F income attributable to covered items would then be separately allocated to US shareholders, consistent with their assignments at the CFC level. When determining attributes specific to the US shareholder (e.g., PTEP or IRC Section 961(c) basis), these attributes would apply to exclude the covered item from the CFC's gross income under IRC Sections 959(b) or 961(c). Subpart F income not attributable to covered items (i.e., non-covered items) would continue to be allocated based on existing rules.

III. IRC Section 961 framework

A. Basis adjustments under IRC Section 961(a) and (b)

IRC Section 961 requires adjustments to a US shareholder's basis in CFC stock to prevent double taxation that would otherwise arise if the stock of the CFC is later sold before the CFC has distributed its PTEP (as the PTEP represents earnings already subject to US taxation). Under IRC Section 961(a), the US shareholder's basis in stock of a CFC, and any property through which the US shareholder owns (indirectly, within the meaning of IRC Section 958(a)(2)) the CFC stock, increases by the amount of any inclusion in the US shareholder's gross income under IRC Sections 951 or 951A. Under IRC Section 961(b), a US shareholder's basis in the CFC stock then decreases by the PTEP distributed by the CFC, with gain recognized to the extent PTEP distributed exceeds basis in the CFC stock.

1. Share-by-share determination

The Proposed Regulations provide for basis adjustments to each "property unit" through which a covered shareholder owns CFC stock. For purposes of IRC Section 961(a) and (b), these property units include: (1) a "section 961(a) ownership unit," meaning a share of CFC stock or a partnership interest held directly by a covered shareholder; and (2) a "derivative ownership unit," meaning a share of CFC stock or a partnership interest owned directly by a partnership and owned indirectly by a covered shareholder (only through partnership interests). The proposed rules specific to partnership interests are discussed later in this Alert.

This share-by-share approach differs considerably from the approach taken under IRC Section 959, under which PTEP accounts are maintained for all stock owned by a covered shareholder, such that PTEP may be blended across shares. As a result, when PTEP from an inclusion on one share of stock but is distributed with respect to a different share of stock, PTEP distribution would be separated from the related IRC Section 961(a) basis. In many instances, this will result in unexpected gain.

2. Timing and amount of adjustments

The Proposed Regulations provide for IRC Section 961(a) basis increases to shares of CFC stock (or other property units) at different times during a CFC's tax year according to a "hypothetical distribution rule" and an "actual distribution rule." Generally, the hypothetical distribution rule would increase a covered shareholder's basis in a property unit on the last day of the CFC's tax year on which it was a CFC (last relevant day). The basis increase would first be made to the share of CFC stock, then to each property unit through which the covered shareholder owns the CFC stock, based on a "hypothetical distribution" of the CFC's earnings through each property unit on the last relevant day of the CFC's tax year.

The increase would typically, but not always, equal the covered shareholder's inclusions under IRC Sections 951 and 951A (income inclusions) by reason of its ownership of the property unit. IRC Sections 951 and 951A also use a hypothetical distribution approach; in certain circumstances, however, the basis increase in the CFC's stock under the Proposed Regulations would differ from the covered shareholder's income inclusions. The Preamble to the Proposed Regulations provides an example of a covered shareholder that owns preferred stock in CFC and is entitled to the first $10x of the CFC's earnings. Where the CFC earns income of $100x, only $90x of which is includible under IRC Sections 951(a) or 951A, the preferred covered shareholder will have an income inclusion of $9x but a basis increase of $10x under the Proposed Regulations (based on a hypothetical distribution of the CFC's earnings). If, instead, the preferred shareholder received only a $9x basis increase, a subsequent PTEP distribution of $10x on the preferred stock would trigger gain recognition under IRC Section 961(b)(2).

Unlike the hypothetical distribution rule, the actual distribution rule would generally increase a covered shareholder's basis in CFC stock on the first day of the CFC's tax year if PTEP were to be distributed during the CFC's tax year on stock owned by the covered shareholder on the last relevant day of the CFC's year. Thus, the rule provides an IRC Section 961(a) basis increase earlier in the CFC's tax year equaling any midyear PTEP distributions to the covered shareholder, rather equaling the covered shareholder's income inclusions. This is designed to align the timing and amount of the basis increase and any basis decrease resulting from the midyear PTEP distribution, preventing improper gain recognition. If PTEP distributions occurred after any midyear change in ownership of the CFC's stock (a midyear transaction), the basis increase would occur immediately after the midyear transaction.

The Proposed Regulations also include rules for basis reductions under IRC Section 961(b). Specifically, a covered shareholder's receipt of a PTEP distribution with respect to a share of stock would reduce the shareholder's basis in the share. The reduction would equal the dollar basis of the PTEP plus any associated foreign taxes for which a foreign tax credit is allowed, but only to the extent that the reduction did not exceed the covered shareholder's basis in that share of CFC stock. For any excess, the covered shareholder would recognize gain equal to that excess in accordance with IRC Section 961(b)(2).

B. IRC Section 961(c) rules

IRC Section 961(c) requires similar basis adjustments as IRC Section 961(a) and (b) to be made to stock of a lower-tier CFC that is owned by an upper-tier CFC but only for purposes of determining the amount included under IRC Section 951 in the gross income of the US shareholder. The Proposed Regulations define these as "section 961(c) ownership units," meaning shares of lower-tier CFC stock that are owned directly by an upper-tier CFC and owned indirectly by a covered shareholder.

1. Shareholder-specific basis tracking

Subject to one significant exception (consolidated groups, discussed later) the Proposed Regulations would require basis adjustments to section 961(c) ownership units to be maintained separately for each covered shareholder that indirectly owns the section 961(c) ownership unit. The timing and amount of adjustments to IRC Section 961(c) basis largely follow the rules described previously, subject to one significant distinction: the Proposed Regulations would permit negative IRC Section 961(c) basis, subject to limitations. Under successor rules, IRC Section 961(c) basis could be transferred to another covered shareholder when the covered shareholder transferred the relevant foreign corporation's stock in a general successor transaction.

2. Effects of IRC Section 961(c) basis

The Proposed Regulations would exclude PTEP resulting from covered gain to which IRC Section 961(c) basis applies from a CFC's gross subpart F income and tested income. This would resolve outstanding questions as to the scope of IRC Section 961(c), which refers solely to IRC Section 951 (subpart F income) and not IRC Section 951A (GILTI). Specifically, when a CFC transfers stock in another CFC, the Proposed Regulations would require the transferring CFC to determine covered gain without regard to loss recognized on any transferred unit or IRC Section 961(c) basis. Covered gain would be assigned to each covered shareholder under the hypothetical distribution approach for assigning covered items to a CFC in Prop. Reg. Section 1.951-2. To the extent that the CFC's IRC Section 961(c) basis with respect to the covered shareholder applied, the assigned covered gain would be excluded from the CFC's gross subpart F income and gross tested income.

The resulting gain would be itself treated as PTEP, generally mirroring the character of the PTEP in the stock on which gain was reduced. In addition, IRC Section 961(c) gain would arise solely for purposes of determining a covered shareholder's income inclusion but would not impact a CFC's gross income for purposes of IRC Sections 951A or 952, nor would it increase a CFC's E&P (i.e., the PTEP distribution would increase the E&P, so any increase attributable to the gain recognition would be duplicative). Foreign income taxes imposed on that mirrored PTEP would be treated as PTEP group taxes, potentially available to be claimed as a foreign tax credit under IRC Section 960(b) when the mirrored PTEP was distributed.

3. Distributions; negative IRC Section 961(c) basis

Distributions of PTEP to a CFC would reduce IRC Section 961(c) basis. The reduction would equal the equivalent of the covered shareholder's US dollar basis in the PTEP plus the related PTEP taxes. A distribution of PTEP exceeding a covered shareholder's IRC Section 961(c) basis would result in negative IRC Section 961(c) basis, but only to the extent of the covered shareholder's portion of the CFC's adjusted basis. PTEP distributions exceeding that limitation would be treated as gain from the sale or exchange of the stock on which the PTEP was distributed, and assigned to the covered shareholder under the new proposed pro-rata-share rules.

In some cases, a covered shareholder would also be required to recognize gain under IRC Section 961(c) following (1) transactions in which the true adjusted basis of stock with existing negative IRC Section 961(c) basis becomes relevant, or (2) sales, exchanges or dispositions of the stock, including nonrecognition transactions, redemptions or other transactions in which the IRC Section 961(c) basis could potentially be preserved.

The Proposed Regulations would not treat gain recognized under IRC Section 961(c) as subpart F income or gross income. Instead, the Proposed Regulations would treat IRC Section 961(c) income as a new, distinct type of gross income that a CFC could recognize and that a US shareholder of a CFC would have to include. As a result, losses in property that would otherwise reduce gain in stock for purposes of determining subpart F income could not be netted against IRC Section 961(c) gain. Similarly, losses arising from IRC Section 961(c) basis could not offset gain in any other property, although the Proposed Regulations would permit those losses to offset gain attributable to stock in the same foreign corporation.

IV. Partnership rules

Under current law, a US partner in a partnership (foreign or domestic) that owns CFC stock is treated as owning its proportionate share of that CFC stock for purposes of applying IRC Sections 951A, 951(a), and related provisions. If the partner is a U.S. shareholder of the CFC, it must (1) include its proportionate share of the CFC's subpart F income and GILTI tested income, and (2) increase its outside basis in the partnership under IRC Section 961(a) to reflect these income inclusions.

Under current law, there is substantial uncertainty over whether the partnership's "inside basis" in the CFC stock similarly increases because the partnership is not a US. shareholder and is not required to include subpart F income or GILTI tested income. If the partnership's "inside basis" does not increase, this inside/outside basis disparity could lead to distortions (e.g., additional gain when a partnership sells CFC stock with respect to which its U.S. shareholder partners have had income inclusions but where the CFC has not yet distributed the related earnings).

The Proposed Regulations would address this uncertainty for US partners of partnerships that own CFC stock, not for CFC partners of partnerships. The IRS is continuing to review issues regarding the latter set of potential IRC Section 961(c) adjustments.

The Proposed Regulations would cause a partnership to increase its "derived basis" in any (1) share of CFC stock owned directly by the partnership and (2) interest in a lower-tier partnership that owns CFC stock (each, a "derivative ownership unit") with respect to a covered shareholder (generally, a U.S. shareholder that includes income under IRC Sections 951A or 951(a), or the U.S. shareholder's successor). Derived basis is specific to each partner and, according to the Preamble, is "intended to operate in a manner similar to a basis adjustment under section 743(b)."² Derived basis has no effect on the partnership's common basis (i.e., the basis shared by all partners) in the derivative ownership units or any other asset of the partnership.

The Proposed Regulations would require a partnership to (1) increase its derived basis with respect to a U.S. shareholder partner to reflect this partner's inclusions of subpart F income and GILTI tested income, and (2) decrease its derived basis with respect to a U.S. shareholder partner to reflect distributions of PTEP that are excluded from the partner's gross income under IRC Section 959 and the Proposed Regulations.

If a partnership were to sell CFC stock and have positive derived basis with respect to a U.S. shareholder partner, the partnership would apply that positive derived basis to reduce the partner's distributive share of partnership gain (or increase distributive share of partnership loss, subject to certain limitations), similar to how an IRC Section 743(b) adjustment operates.

If a partner were to sell an interest in a partnership that directly or indirectly holds CFC stock, the transferor's PTEP account balances and derived basis would generally be transferred to the transferee (subject to certain adjustments). Any derived basis so transferred would be taken into account to compute the transferee's IRC Section 743(b) adjustment.

The Proposed Regulations contain additional rules for tiered partnership structures and situations in which a partnership has negative derived basis with respect to a partner. The Proposed Regulations do not address the interaction of derived basis with the partnership distribution rules (e.g., IRC Sections 732 and 734) and request comments on the foregoing and other open issues.

V. Consolidated return rules

A. Single shareholder approach to PTEP

The Proposed Regulations would adopt rules specific to members of a consolidated group, with a hybrid approach to PTEP under IRC Section 959 and basis adjustments under IRC Section 961. For IRC Section 959 purposes, the members of a consolidated group would be treated as a single covered shareholder, establishing and maintaining a single set of annual PTEP accounts, dollar basis pools and PTEP tax pools for foreign corporation stock owned by one or more members of the consolidated group. However, each member would compute and take into account its own items with respect to foreign corporation stock. For example, to the extent a member were to receive a distribution from a foreign corporation, that member would take into account the tax consequences of the distribution. In addition, a foreign corporation would establish and maintain a single corporate PTEP account and corporate PTEP tax pool with respect to a consolidated group. According to the Preamble, these rules are intended to prevent a consolidated group from altering PTEP characterization of distributions by changing which member owns foreign corporation stock.

B. Hybrid treatment for IRC Section 961 basis

For IRC Section 961 purposes, a mix of single- and separate-entity treatment would apply for different types of property units. For section 961(a) ownership units, adjustments would be made separately to each member's actual ownership interests. This separate-entity treatment could result in gain recognition under IRC Section 961(b)(2) if the distributee member were to have insufficient basis in its shares, even if other members had basis by reason of the distributed PTEP. (This could occur, for example, in the context of a dividend equivalent redemption in which the member's PTEP distribution exceeds its inclusions that gave rise to PTEP.) In contrast, for derivative ownership units and section 961(c) ownership units, members would be treated as a single covered shareholder, maintaining a single derived basis and IRC Section 961(c) basis, respectively, for the consolidated group. To reduce basis and recognize gain, the Proposed Regulations would allocate the consolidated group's single basis to members and compute basis reductions and potential IRC Section 961(c) gain by comparing the allocated basis to the member's share of the covered item (i.e., a PTEP distribution or gain in CFC stock).

Adjustments for income inclusions (under IRC Sections 951(a), 951A(a), and 961) and foreign currency gains (under IRC Section 986(c)) would also be determined based on each member's respective inclusions. To the extent the adjustments would be to section 961(a) ownership units, such adjustments would be made separately, while adjustments to derivative and section 961(c) ownership units would be made to the derived basis or the IRC Section 961(c) basis of the group, respectively.

Reductions to section 961(a) ownership units for distributions of PTEP and foreign currency loss would be determined on a separate-entity basis. For derived basis and IRC Section 961(c) basis, the group's basis would be allocated to members by comparing the allocated basis to the member's share of the covered item (i.e., a PTEP distribution or gain in CFC stock), with reductions made (and gain recognized) separately, and then the derived basis and IRC Section 961(c) basis recombined.

C. Joining or leaving the consolidated group

The Proposed Regulations would also address the application of IRC Sections 959 and 961 rules when a member shareholder joins or leaves a consolidated group, treating such transactions as acquisitions or dispositions of foreign corporation stock owned by the member at the time.

For joining transactions, the joining member would be treated as the transferor covered shareholder, and the consolidated group as the successor covered shareholder, acquiring all foreign corporation stock owned by the joining member in a general successor transaction. Thus, PTEP in the joining member's annual PTEP accounts would be added to the consolidated group's accounts, and IRC Section 961(c) basis or derived basis would be combined with the group's basis in the respective ownership units.

For departing transactions, the consolidated group would be treated as the transferor covered shareholder; the departing member, as the successor covered shareholder, would be treated as if it acquired all the foreign corporation stock it owned at the time. PTEP, IRC Section 961(c) basis, and derived basis would be allocated between the group and the departing member.

The Proposed Regulations also specify that joining and departing transactions do not result in the recognition of foreign currency gain or loss under IRC Section 986(c), with the dollar basis of PTEP in a joining member's annual PTEP accounts carrying over to the consolidated group's annual PTEP accounts.

VI. Foreign currency rules

The Proposed Regulations, generally consistent with the 1988 Notice, outline two situations in which a covered shareholder recognizes foreign currency gain or loss under IRC Section 986(c) with respect to PTEP: when PTEP is distributed to the covered shareholder (including PTEP treated as received through a partnership) and when PTEP no longer pertains to the covered shareholder (e.g., due to an election under IRC Section 338(g) or a transfer of the CFC to another covered shareholder in a general successor transaction). The Proposed Regulations would provide that no foreign currency gain or loss is recognized in a distribution of PTEP to a foreign corporation or when PTEP transfers in a transaction other than a general successor transaction.

Foreign currency gain or loss recognized with respect to PTEP would be recognized concurrently with the transaction requiring recognition of the gain or loss. Foreign currency gain or loss under IRC Section 986(c) would be computed by subtracting the dollar basis of the PTEP from the US dollar amount of the PTEP (determined by translating the PTEP at the spot rate on the date of the transaction). A positive difference would be foreign currency gain and a negative difference would be foreign currency loss. This foreign currency gain or loss would be treated as ordinary income or loss from the same source and relating to the same IRC Section 904 category as the income inclusion that gave rise to the PTEP.

To reflect a covered shareholder's foreign currency gain or loss under IRC Section 986(c) with respect to a foreign corporation's PTEP in a general successor transaction or other transaction without a PTEP distribution, the Proposed Regulations include rules to adjust the basis of property units that are shares of foreign corporation stock owned by the covered shareholder by the net foreign currency gain or loss. These adjustments "tier up" through any property units through which the covered shareholder owns such stock, resulting in adjustments to the basis of such property units.

Under current Treas. Reg. Section 1.985-5(e)(2), a US shareholder of a CFC must recognize foreign currency gain or loss with respect to PTEP when the CFC changes its functional currency to the US dollar. The Preamble notes that the comprehensive tracking system for the dollar basis of PTEP included in the Proposed Regulations (as discussed previously) alleviates any prior concern behind Treas. Reg. Section 1.985-5(e)(2) (e.g., administrative difficulties in maintaining a US dollar basis in PTEP measured in the US dollar). Therefore, the Proposed Regulations would withdraw Treas. Reg. Section 1.985-5(e)(2).

VII. IRC Section 962

IRC Section 962 permits an individual US shareholder to elect to be taxed at domestic corporate rates on its IRC Section 951(a) and Section 951A inclusions, which are then treated as taken into account by a domestic corporation for purposes of computed deemed paid foreign tax credits under IRC Section 960. IRC Section 962 is intended to treat an individual shareholder of a CFC as if it owned the CFC through a domestic corporation through the following two mechanisms. Under IRC Section 962(d), distributed PTEP is included in the individual's gross income (despite IRC Section 959(a)(1)) to the extent it exceeds the tax paid on the amounts to which the IRC Section 962 election applies (taxable IRC Section 962 PTEP). IRC Section 961(a) limits a basis increase for an income inclusion to which the election applies to the tax paid by the individual and IRC Section 961(b)(1) limits a basis decrease to the amount excluded from gross income after application of IRC Section 962(d).

The Proposed Regulations would largely apply the previously discussed principles under IRC Sections 962(d), 961(a), and 961(b)(1) for distributions of IRC Section 962 PTEP. However, for a distribution to a CFC or a stock disposition by CFC, the Proposed Regulations would apply IRC Section 959(b) to exclude an income inclusion and provide IRC Section 961(c) basis for taxable IRC Section 962 PTEP. The Proposed Regulations additionally provide that taxable IRC Section 962 PTEP preserves its character in a general successor transaction and may be reflected in PTEP arising from IRC Section 961(c) basis. Lastly, Treas. Reg. Section 1.962-3 (governing treatment of actual distributions) is proposed to be removed as the rules are generally incorporated in the Proposed Regulations under IRC Section 959.

VIII. Anti-avoidance rules

The Proposed Regulations include anti-avoidance rules, under which "appropriate adjustments" would be required if a taxpayer were to engage in "a transaction, series of transactions, plan, or arrangement … with a principal purpose of avoiding the purposes of section 959 and the section 959 regulations." The Preamble explains that these rules aim to address transactions intended to produce double non-taxation, such as the conversion of E&P distributions from PTEP (eligible for tax-free treatment under IRC Section 959, but with a basis reduction under IRC Section 961) to IRC Section 959(c)(3) E&P (giving rise to a deduction under IRC Section 245A, with no basis reduction) or vice versa.

IX. Implementation and transition rules

Most provisions of the Proposed Regulations would apply to foreign corporations' tax years beginning on or after the date the Proposed Regulations are finalized, and to tax years of persons for which the foreign corporations' tax years are relevant (general applicability date).

Notwithstanding the general applicability date, portions of the Proposed Regulations under IRC Section 959 regulations related to the 2019 Notice would retroactively apply to US shareholders' tax years (and successors in interest) ending after 14 December 2018, and foreign corporations' tax years ending with or within those tax years (2019 Notice years). For 2019 Notice years, taxpayers would generally have to apply rules in proposed Treas. Reg. Sections 1.959-1(c) (treatment of S corporations), 1.959-2 (accounting of PTEP), 1.959-3 (adjustments to shareholder and foreign corporation accounts), 1.959-4(e) (allocation of distributions), and 1.959-5(d) (allocation of IRC Section 956 amounts), and relevant definitions in Treas. Reg. Section 1.959-1(b).

Taxpayers could apply the Proposed Regulations early to foreign corporations' tax years beginning before the general applicability date, provided certain conditions were met. In particular, taxpayers would be required to apply the Proposed Regulations in their entirety to the early-application year, all succeeding years, all relevant tax years of covered shareholders, and all related foreign corporations' tax years ending on or after the last day of the first early application year. Each covered shareholder would be required to confirm that all relevant tax years are open under IRC Section 6501 and provide written consent to apply the Proposed Regulations early.

Transition rules are included for establishing and conforming accounts under IRC Section 959, as well as for establishing derived basis and IRC Section 961(c) basis, for the initial application of the Proposed Regulations. For the former, the transition rules would generally require taxpayers to use a reasonable method to establish annual PTEP accounts, dollar basis pools, and corporate PTEP accounts at the beginning of the first tax year to which the Proposed Regulations under IRC Section 959 apply. For the latter, taxpayers would generally be required to establish a partnership's derived basis or a CFC's IRC Section 961(c) basis of a property unit using a reasonable method as of the beginning of the first tax year of the foreign corporation to which the Proposed Regulations under IRC Section 961 would apply.

X. Implications

The Proposed Regulations include significant changes to current law. Extensive account maintenance and basis-tracking requirements would introduce significant complexity that many taxpayers are likely to find burdensome. Moreover, the transition rules would require taxpayers to construct those accounts by reference to a CFC's entire history, which will often be an extensive undertaking. Similarly, the regulations would require PTEP accounts to be maintained (or reconstructed) when foreign persons that are "deemed covered shareholders" own foreign corporation stock, which could significantly increase compliance burdens and information-sharing requirements in mergers and acquisitions.

The recognition of gain by reason of PTEP distributions from lower-tier CFCs is likely to be far more common than many taxpayers would expect. Many taxpayers will, after reconstructing PTEP accounts and IRC Section 961(c) basis, find that they have more PTEP than basis because distributions of IRC Section 965(b) PTEP did not correspond to IRC Section 961(c) basis. Even taxpayers that have distributed all IRC Section 965(b) PTEP may face a basis shortage, as that PTEP would have reduced other IRC Section 961(c) basis.

Unexpected gain may also arise because (1) the manner in which PTEP distributions were made may differ from the manner in which IRC Section 961(c) increases arose; and (2) IRC Section 961(c) losses may not be used by other shareholders or against gains from property other than stock in the same foreign corporation. Taxpayers should consider whether PTEP distributions, nontaxable liquidations or reorganizations, or other transactions in advance of the Proposed Regulations' finalization would minimize this potential for accelerated gain.

The Proposed Regulations do, however, include several favorable rules. Clarification that IRC Section 961(c) basis reduces tested income prevents unnecessary double taxation. Although complex in many respects, the Proposed Regulations would clearly establish partnership inside basis in CFC stock, which could allow taxpayers to avoid an inappropriate timing result (and potential double taxation) when a partnership sells its CFC stock. This change is particularly helpful for tiered partnership structures, including certain investment fund structures, where the indirect owners have little flexibility to initially restructure a CFC's ownership (or to cause a CFC to make certain distributions) just to avoid an inappropriate tax result. Finally, the Proposed Regulations' treatment of stock gain to which IRC Section 961(c) basis applies as PTEP would result in more taxes (including nonresident capital gains taxes) to be associated with PTEP, potentially increasing the foreign tax credits allowed to taxpayers under IRC Section 960(b).