On 2 December 2024, the Treasury Department and IRS published comprehensive proposed regulations (REG-105479-18) addressing previously taxed earnings and profits (PTEP) of foreign corporations and related basis adjustments. These long-awaited proposed regulations provide detailed guidance under IRC Sections 959 and 961, as well as related provisions, and would represent the first major update to the PTEP regulations since 1965. The proposed regulations address both longstanding issues and new complexities introduced by the Tax Cuts and Jobs Act of 2017 (TCJA).

The proposed PTEP regulations will be welcomed by certain taxpayers, including partners in investment partnerships (or partnerships that otherwise own controlled foreign corporation (CFC) stock). Under current law, a partnership arguably does not obtain basis under IRC Section 961 for its interests in CFC stock, potentially resulting in double taxation for sales of stock by partnerships. As a result, these taxpayers may wish to apply these regulations early.

Many other taxpayers, however, are likely to criticize the administrative burdens of maintaining PTEP (and related) accounts and IRC Section 961 basis. Moreover, the proposed regulations would require sharing of PTEP across (1) different shares of stock; (2) different chains of ownership; and (3) in certain circumstances, different shareholders (that are members of the same consolidated group). The proposed regulations would not, however, permit the sharing of IRC Section 961(a) basis, IRC Section 961(c) basis or derived basis; because of this mismatch, excess gains could arise. Finally, the derived basis rules and IRC Section 961(c) basis rules could cause gain recognition in otherwise nonrecognition transactions and other unanticipated circumstances. As a result of these and certain other rules, many taxpayers are unlikely to apply these regulations until they are finalized.

With the upcoming change in administration and the potential for legislative action in 2025, it is unclear when these regulations will be finalized and, if so, whether significant changes will be made.

This First Impressions Alerts provides a high-level overview of the proposed regulations. A more detailed Alert on the regulations is forthcoming.

Background

The PTEP regime was originally designed to prevent double taxation of foreign corporate earnings that have already been subject to US tax through various inclusion provisions. When a US shareholder must include amounts in income under subpart F (IRC Section 951(a)) or GILTI (IRC Section 951A), the subsequent distribution of those previously taxed earnings is generally excluded from income under IRC Section 959. IRC Section 961 provides corresponding basis adjustments to prevent both double taxation and inappropriate tax benefits.

The TCJA dramatically expanded the PTEP regime's scope and complexity by (1) increasing PTEP through the IRC Section 965 transition tax and GILTI regime, (2) creating new PTEP categories requiring different treatment for foreign tax credits and currency gain/loss, and (3) introducing IRC Section 245A, which interacts with PTEP by allowing tax-free repatriation of non-PTEP earnings in certain cases. These changes, combined with IRC Section 986(c) in the Tax Reform Act of 1986 (1986 Act), which requires recognition of currency gain/loss on PTEP distributions, made modernization of the 1965 regulations critical.

Several of these aspects were addressed in Notice 88-71, 1988-2 CB 374 (1988 Notice, which addressed certain foreign currency issues under the 1986 Act) and Notice 2019-01, 2019-02 IRB 275 (2019 Notice, which addressed the PTEP ordering rule and other topics). The proposed regulations aim to provide a comprehensive framework for tracking and calculating PTEP, related basis adjustments, and foreign currency gain or loss across multiple tiers of ownership.

PTEP accounts and associated attributes

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 proposed regulations would establish a two-level system for PTEP tracking. Covered shareholders would maintain annual PTEP accounts to track their PTEP by year and IRC Section 904 categories across 10 PTEP groups. Separately, foreign corporations would maintain corporate-level PTEP accounts corresponding to each covered shareholder's accounts. Both levels would track associated dollar basis pools (for currency calculations) and tax pools (for foreign tax credits). While taxpayers would generally maintain these pools annually, they could instead elect to combine pools across years within IRC Section 904 categories.

The proposed regulations also contain rules on timing and ordering. In particular, they would adjust PTEP accounts at three different times: at the beginning of the tax year; at the end of the tax year; and when certain transactions occur. IRC Section 961 basis adjustments (described later) would generally occur at the same time as PTEP account adjustments. PTEP account increases and corresponding IRC Section 961 basis increases attributable to an inclusion of subpart F income or GILTI would generally occur at the beginning of the year (even though the inclusion itself would occur at the end of the year); as a result, distributions of current-year PTEP would not generally result in IRC Section 961(b)(2) gain.

Finally, consistent with the 2019 Notice, the proposed regulations would generally treat distributions of PTEP as occurring on a last-in, first-out basis; any IRC Section 965 PTEP, however, would be treated as distributed first.

New rules on IRC Section 951 PTEP pro rata shares

The proposed regulations would fundamentally change how PTEP affects subpart F calculations by first assigning "covered items" (distributions and gains potentially eligible for PTEP treatment) to specific shareholders before determining subpart F treatment. This shareholder-specific approach would replace Revenue Ruling 82-16's entity-level "gross-up" mechanism, ensuring PTEP benefits would apply only for appropriate shareholders.

Basis adjustments under IRC Section 961

The proposed regulations provide comprehensive rules for basis adjustments under IRC Section 961, which operates to prevent both double taxation of PTEP and inappropriate tax benefits. The basic purpose of IRC Section 961(a) is to increase basis to reflect amounts included in income under IRC Sections 951(a) or 951A, preventing gain recognition when undistributed PTEP is reflected in stock value. IRC Section 961(b) then requires basis reductions when PTEP is distributed to prevent the creation of artificial losses.

If a US shareholder owns CFC stock through another CFC, IRC Section 961(c) requires that, under regulations, "adjustments" similar to the adjustments under IRC Section 961(a) and (b) to be made to the basis of that stock, and the basis of stock in any other CFC through which the US shareholder owns the stock of the first CFC, but only for the purposes of IRC Section 951. The proposed regulations would address one key longstanding uncertainty by applying IRC Section 961(c) basis for purposes of excluding gain from both subpart F income and tested income. Further, 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 earnings and profits (i.e., the PTEP distribution would increase those earnings and profits, so any increase attributable to the gain recognition would be duplicative).

The proposed regulations would also establish three distinct basis categories: (1) IRC Section 961(a) basis for directly-held shares and partnership interests, applied strictly share-by-share with no sharing permitted; (2) derived basis for partnerships owning CFC stock, maintained by the shareholder and potentially becoming negative; and (3) IRC Section 961(c) basis for CFC-owned shares, also maintained by the shareholder. The share-by-share approach to IRC Section 961(a) basis, when combined with the potential for PTEP sharing, could result in unexpected gain recognition. Further, both derived basis and IRC Section 961(c) basis could trigger gain recognition in two scenarios: (1) PTEP distributions result in negative derived basis or negative IRC Section 961(c) basis that exceeds the covered shareholder's share of common or adjusted basis, respectively, and (2) existing negative basis encounters certain triggering events like nonrecognition transactions or CFC stock transfers. Losses arising from IRC Section 961(c) basis could not be offset against gain (other than gain attributable to stock in the same foreign corporation).

Consolidated groups

For consolidated groups, the proposed regulations would adopt a hybrid approach to PTEP and basis. Groups would be treated as a single covered shareholder for PTEP purposes, maintaining a single set of annual PTEP accounts, dollar basis pools, and PTEP tax pools for each foreign corporation owned by any member. This single-entity treatment would prevent groups from manipulating PTEP characterization by changing which member owns foreign corporation stock. To prevent basis shifting between members, the proposed regulations would respect each member's separate basis in its directly held shares and partnership interests. Thus, a distribution of PTEP 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 adequate basis.

Applicability dates and transition rules

The proposed regulations have multiple effective dates. Certain core IRC Section 959 provisions described in Notice 2019-01 would apply retroactively to years ending after December 14, 2018. Most provisions would apply prospectively to tax years beginning after finalization, but taxpayers could elect early application if they applied the rules consistently and had open statute years. The proposed regulations include detailed transition rules for establishing initial account balances and basis amounts, with special provisions addressing the shift to aggregate treatment for partnerships under the IRC Section 958 regulations.