SECTION 959 PREVIOUSLY TAXED INCOME OF A CFC

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1 SECTION 959 PREVIOUSLY TAXED INCOME OF A CFC John Robert Cohn, Partner Thompson & Knight LLP Dallas, Texas U.S. TAX PLANNING FOR CFCs UNDER SUBPART F

2 You ve picked up a subpart F inclusion now what do you do? You receive a distribution am I taxed again?

3 OVERVIEW Section 959 General Operating Rules Consequences of PTI Distributions Successor Rules Proposed Regulations Section 986(c) / / 3

4 SECTION 959

5 SECTION 959 GENERAL OPERATING RULES General Rule: Previously taxed earnings and profits ( PTI ) are not subject to U.S. tax when distributed Purpose: To prevent double taxation of amounts already subject to U.S. tax Requirements: Earnings and profits must have been included in the gross income of a U.S. Shareholder (sec. 951(b)) Shareholder level attribute Earnings and profits attributable to shares held by foreign persons and less than 10% domestic shareholders not eligible for PTI treatment / / 5

6 SECTION 959 GENERAL OPERATING RULES What types of income create PTI? Subpart F Income Increases in Earnings Invested in U.S. Property (i.e., section 956 inclusions) E&P subject to taxation under section 1248 Previously Excluded Subpart F Income Withdrawn from Investment in Less Developed Countries (pre- 75 Subpart F income) Previously Excluded Subpart F Income Withdrawn from Investment in Foreign Base Company Shipping Operations (pre- 87 Subpart F income) / / 6

7 SECTION 959 GENERAL OPERATING RULES General Operating Rules Payment to a U.S. Shareholder (or successor) must be characterized as a distribution for U.S. tax purposes Actual distributions Distributions under section 302 (i.e., redemptions) characterized as dividends under section 301 Certain deemed distributions Includes section 304 distributions Certain transfers characterized as distributions under foreign law may not give rise to PTI e.g., loans treated as constructive distributions under foreign law E&P deficits do not prevent PTI distributions / / 7

8 SECTION 959 General operating rules (cont.) Recipient does not need to be a U.S. Shareholder of the distributing foreign corporation at the time of distribution See successor rules (below) Distributing foreign corporation does not need to be a CFC at the time of distribution / / 8

9 SECTION 959 GENERAL OPERATING RULES Consequences of a PTI distribution Not treated as a dividend Exceptions: > Treated as a dividend for purposes of determining the credit available for foreign taxes paid with respect to a distribution of foreign taxes > Treated as a dividend for section 1411 (the 3.8% Medicare tax) Adjustments to PTI Accounts Reduction in PTI accounts of distributing foreign corporation Increase in PTI accounts of recipient foreign corporation Proposed Regulations adopt PTI leveling concept where U.S. Shareholder holders multiple blocks of stock / / 9

10 SECTION DISTRIBUTIONS Facts Current Year Distribution CFC earns $100 subpart F income in Year 1 CFC s current and accumulated E&P (before distributions) is $150 CFC makes $50 distribution to US Parent in Year 1 US Tax Consequences US Parent includes $100 in income as a subpart F inclusion in Year 1 US Parent is not taxed on receipt of $50 distribution in Year 1 under section 959 * * * * * $100 Subpart F Inclusion $100 Subpart F Income US Parent CFC $50 Distribution Facts - Subsequent Year Distribution CFC earns $100 subpart F income in Year 1 CFC s current and accumulated E&P (before distributions) is $150 CFC makes $50 distribution to US Parent in Year 2 * Facts assume E&P in excess of subpart F amounts. US Tax Consequences US Parent includes $100 in income as a subpart F inclusion in Year 1 US Parent is not taxed on receipt of $50 distribution in Year 2 under section 959 / / 10

11 SECTION 959 SECTION 956 INCLUSIONS Facts Current Year Distribution CFC earns $100 subpart F income in Year 1 CFC invests $50 in U.S. Property in Year 1 US Tax Consequences US Parent includes $100 in income as a subpart F inclusion in Year 1 CFC s investment in U.S. Property does not result in a section 956 inclusion * * * * * $100 Subpart F Inclusion $100 Subpart F Income US Parent CFC $50 Investment in US Property Facts - Subsequent Year Distribution Same as above, except that CFC makes investment in U.S. Property in Year 2 US Property US Tax Consequences Same as above i.e., investment in U.S. property does not result in section 956 inclusion * Facts assume E&P in excess of subpart F amounts. / / 11

12 SECTION 959 TIERED DISTRIBUTIONS Tiered Distributions Similar PTI treatment applies to distributions between CFCs An upper-tier CFC that receives a distribution of PTI from a lower-tier CFC is not required to include the distribution in income Recipient CFC accounts for the PTI in the same manner (i.e., category and year) as the distributing CFC (discussed below) / / 12

13 SECTION 959 TIERED DISTRIBUTIONS Facts Current Year Distribution CFC3 earns $100 subpart F income in Year 1 CFC3 makes $50 distribution to CFC2 in Year 1 CFC2 makes $50 distribution to CFC1 in Year 1 CFC1 makes $50 distribution to US Parent in Year 1 US Tax Consequences US Parent includes $100 in income as a subpart F inclusion in Year 1 Distribution from CFC3 to CFC2 is not treated as income to CFC2 Distribution from CFC2 to CFC1 is not treated as income to CFC1 US Parent is not taxed on receipt of $50 distribution from CFC1 * * * * * $100 Subpart F Inclusion $100 Subpart F Income US Parent CFC 1 CFC 2 CFC 3 $50 Distribution $50 Distribution $50 Distribution Facts - Subsequent Year Distribution Same as above, except distributions are not made until Year 2 * Facts assume E&P in excess of subpart F amounts. US Tax Consequences Same as above i.e., distributions of PTI are not included in income / / 13

14 SECTION 959 TIERED DISTRIBUTIONS Facts Current Year Distribution CFC3 earns $100 subpart F income in Year 1 CFC3 distributes $50 to CFC2 in Year 1 CFC2 invests $50 in U.S. Property in Year 1 US Tax Consequences US Parent includes $100 in income as a subpart F inclusion in Year 1 CFC2 does not include distribution in gross income CFC2 s investment in U.S. Property does not result in a section 956 inclusion * * * * * Facts - Subsequent Year Distribution Same as above, except that CFC2 makes investment in U.S. Property in Year 2 $100 Subpart F Inclusion $100 Subpart F Income $50 Distribution US Parent CFC 1 CFC 2 CFC 3 $50 Investment in US Property US Property US Tax Consequences Same as above i.e., investment in U.S. property does not result in section 956 inclusion * Facts assume E&P in excess of subpart F amounts. / / 14

15 SECTION 959 ALLOCATIONS General Rules Ordering Rules (c)(1) 956 Inclusions (c)(2) Subpart F Income Reduced by amounts invested in U.S. Property (c)(3) Non-Previously Taxed Earnings LIFO approach Lower-tier CFC earnings distributed before upper-tier CFC earnings / / 15

16 SECTION 959 ALLOCATIONS Demonstrating the ordering rules Sec. 956 Subpart F Other LIFO US Parent CFC Year (c)(1) (c)(2) Subpart F (c)(3) - Other $150 Distribution (x3) Amount Year Allocation Distribution #1 - $ Year 2 (c)(1) 50 Year 1 (c)(1) 150 Distribution #2 - $ Year 1 (c)(1) 75 Year 3 (c)(2) 25 Year 2 (c)(2) 150 Distribution #3 - $ Year 2 (c)(2) 50 Year 4 (c)(3) 50 Year 3 (c)(3) 150 / / 16

17 SECTION 959 ALLOCATIONS Distributions between CFCs Allocated to the same category of the distributing CFC Allocated to the same year in which incurred by the distributing CFC / / 17

18 SECTION 959 ALLOCATIONS CFC 2 Pre-Distribution Year (c)(1) (c)(2) (c)(3) US Parent CFC1 $150 Distribution CFC2 CFC 1 Pre-Distribution Year (c)(1) (c)(2) (c)(3) CFC 2 Post-Distribution Year (c)(1) (c)(2) (c)(3) 1 0 (50-50) 2 50 (75-25) (75-75) 4 50 CFC 1 Post-Distribution Year (c)(1) (c)(2) (c)(3) (100+50) (75+25) (75+75) 4 50 / / 18

19 SECTION 959 FOREIGN TAXES FACTS YEAR 1 CFC2 earns $150 subpart F income in Year 1 US TAX CONSEQUENCES US Parent includes $150 in income as a subpart F inclusion in Year 1 CFC2 has $150 of PTI in the (c)(2) category * * * * * $150 Distribution US Parent CFC1 $10 Foreign Tax FACTS YEAR 2 CFC2 distributes $150 to CFC1 in Year 2 CFC2 $20 Withholding Tax Distribution is subject to $20 of withholding tax in CFC2 s country of incorporation Net Distribution of $120 CFC1 is subject to $10 of foreign tax upon receipt of the distribution in its country of incorporation US TAX CONSEQUENCES CFC2 reduces its PTI account for the (c)(2) category from $150 to $0 CFC1 increases its (c)(2) account by $120 ($150 net of $20 withholding tax and $10 of foreign income tax) / / 19

20 SECTION 959 SUCCESSORS Successors to U.S. Shareholders that previously included CFC earnings and profits in gross income may exclude distributions of PTI from gross income. US Parent Foreign Person Successor treatment applies to purchases/acquisitions of CFC shares from: U.S. Shareholders U.S./non-U.S. persons that acquired CFC shares from U.S. Shareholder Upper-tier CFCs (e.g., a purchase of CFC3 shares from CFC2) US Person CFC 1 CFC 2 CFC 3 / / 20

21 SECTION 959 SUCCESSORS Information required to be furnished: 1. Identity of distributing foreign corporation 2. Identify of person from whom interest in distributing foreign corporation was acquired 3. Description of interest in distributing foreign corporation 4. Amount of exclusion being claimed under section Evidence showing that the E&P for which an exclusion is being claimed Has been included in the gross income of a U.S. Shareholder Has not been previously excluded from the gross income of a U.S. Person / / 21

22 PROPOSED REGULATIONS (2006)

23 SECTION PROPOSED REGULATIONS Effective date: The proposed regulations would apply to tax years of foreign corporations beginning on or after the date they are published as final, and tax years of U.S. shareholders with or within which such tax years of foreign corporations end. After these regulations become effective, foreign corporations and shareholders who are currently accounting for PTI in a manner other than that which is provided in these regulations may use any reasonable method to conform their current accounting of PTI to the rules provided in these regulations. / / 23

24 SECTION 959 PROPOSED REGULATIONS Overview Previously Taxed Earnings and Profits Accounts Multiple Blocks of Stock Consolidated Groups Split Ownership Issues Section 304 Transactions / / 24

25 SECTION PROPOSED REGULATIONS Previously Taxed Earnings and Profits Accounts Shareholder-level accounts Account must be maintained for each share in the functional currency of the foreign corporation > May elect to maintain accounts on dollar pooling basis (discussed below) Accounts may be maintained on a block basis Accounts remain in existence even if shares held by non-u.s. persons Corporate-level account / / 25

26 SECTION PROPOSED REGULATIONS Previously Taxed Earnings and Profits Accounts (cont.) Foreign taxes paid with respect to distributions of PTI maintained in account separate from post-1986 foreign income taxes Foreign taxes deemed paid when PTI distributed / / 26

27 SECTION PROPOSED REGULATIONS Multiple Blocks of Stock Premise: A U.S. Shareholder holds multiple blocks of CFC stock with varying PTI account balances CFC makes a distribution which exceeds the PTI balance for some shares (low-pti shares), but not for others (high-pti shares) Proposed Regulations PTI from high-pti shares reallocated to low-pti shares Compare with Unified Loss Rules in consolidated return regulations (basis leveling) / / 27

28 SECTION PROPOSED REGULATIONS Example Multiple Blocks of Stock With respect to CFC, U.S. Shareholder has one share (Share 1) of stock with $50 of PTI in category (c)(2) one share (Share 2) of stock with $200 of PTI in category (c)(2) CFC has total E&P in excess of $200 CFC distributes $100 with respect to each share / / 28

29 SECTION PROPOSED REGULATIONS Under current regulations: Distribution with respect to Share 1 results in A distribution of $50 of PTI and $50 of non-previously taxed E&P Category (c)(2) account reduced to zero ($50 - $50) Distribution with respect to Share 2 results in A distribution of $100 of PTI Category (c)(2) account reduced to $100 ($200 - $100) / / 29

30 SECTION PROPOSED REGULATIONS Under proposed regulations: PTI Leveling PTI account for Share 2 reduced by $50 PTI account for Share 1 increased by $50 Distribution with respect to Share 1 results in A distribution of $100 of PTI ($50 Share 1; $50 Share 2) Category (c)(2) account reduced to zero ($50 +$50 - $50 - $50) Distribution with respect to Share 2 results in A distribution of $100 of PTI Category (c)(2) account reduced to $50 ($200 - $100 - $50) / / 30

31 SECTION PROPOSED REGULATIONS Consolidated Groups Premise: U.S. Shareholders belong to a U.S. consolidated group Consolidated group members hold CFC stock with varying PTI account balances CFC makes a distribution which exceeds the PTI balance for some members shares (low-pti shares), but not for others (high-pti shares) Proposed Regulations Adopts rule for consolidated groups similar to PTI-leveling rule for multiple blocks of stock PTI from high-pti shares reallocated to low-pti shares Consolidated group rule only applies after PTI-leveling rule for multiple stock blocks / / 31

32 SECTION PROPOSED REGULATIONS Example Consolidated Groups Consolidated group member (Member 1) holds one share of CFC stock with $50 of PTI in category (c)(2) Another consolidated group member (Member 2) holds one share of CFC stock with $200 of PTI in category (c)(2) CFC has total E&P in excess of $200 CFC distributes $100 to each of Member 1 and Member 2 / / 32

33 SECTION PROPOSED REGULATIONS Under current regulations: Result is similar to example above Distribution with respect to Member 1 results in A distribution of $50 of PTI and $50 of non-previously taxed E&P Category (c)(2) account reduced to zero ($50 - $50) Distribution with respect to Member 2 results in A distribution of $100 of PTI Category (c)(2) account reduced to $100 ($200 - $100) / / 33

34 SECTION PROPOSED REGULATIONS Under proposed regulations: PTI Leveling PTI account for Member 2 reduced by $50 PTI account for Member 1 increased by $50 Distribution with respect to Member 1 results in A distribution of $100 of PTI ($50 Share 1; $50 Share 2) Category (c)(2) account reduced to zero ($50 +$50 - $50 - $50) Distribution with respect to Member 2 results in A distribution of $100 of PTI Category (c)(2) account reduced to $50 ($200 - $100 - $50) / / 34

35 SECTION 959 PROPOSED REGULATIONS Facts Current Year Distribution CFC2 earns $100 subpart F income in Year 1 CFC2 distributes $100 to CFC1 in Year 1 US Tax Consequences US Parent includes $70 (pro rata share) in income as a subpart F inclusion in Year 1 Regulations clarify that CFC1 does not include any portion of distribution in gross income i.e., exclusion not limited to $70 that US Parent included in gross income * * * * * $70 Subpart F Inclusion $100 Subpart F Income $100 Distribution US Parent CFC 1 CFC 2 Foreign Shareholder 70% 30% * Facts assume E&P in excess of subpart F amounts. / / 35

36 SECTION 959 PROPOSED REGULATIONS Facts Current Year Distribution CFC2 earns $100 subpart F income in Year 1 Foreign Shareholder sells 30% interest in CFC1 to US Person in Year 2 CFC2 distributes $100 to CFC1 in Year 2 US Tax Consequences US Parent includes $70 (pro rata share) in income as a subpart F inclusion in Year 1 As above, CFC1 does not include any portion of distribution in gross income i.e., exclusion not limited to $70 that US Parent included in gross income US Parent has $70 PTI balance with respect to CFC 1 For purposes of determining subpart F consequences for US person, distribution from CFC2 to CFC1 not excluded from CFC1 s gross income because no amounts have been previously included in the income of US person with respect to those shares US Person includes $30 in gross income as a subpart F inclusion US Person has a $30 PTI account balance with respect to CFC1 * * * * * $70 Subpart F Inclusion $100 Subpart F Income $70 PTI Account (CFC2) $100 Distribution US Parent US Parent 70% 30% CFC 1 CFC 1 CFC 2 Year 1 Transactions CFC 2 Foreign Shareholder Foreign Shareholder Year 2 Transactions 70% 30% Sale * Facts assume E&P in excess of subpart F amounts. US Person / / 36

37 SECTION 959 PROPOSED REGULATIONS Facts Current Year Distribution US Parent sells CFC1 shares to CFC2 for $150 Recast Under Section 304 US Parent makes a deemed contribution of the shares of CFC1 to CFC2 under section 351 transaction in exchange for deemed shares of CFC2 US Parent is deemed to redeem the deemed shares of CFC2 issued in the initial contribution US Tax Consequences of Recast Transaction US Parent and CFC2 do not recognize gain in connection with the deemed section 351 exchange Deemed redemption of CFC2 shares by US Parent is treated as a section 301 distribution Distribution is characterized a dividend to the extent of CFC2 s E&P and, if necessary, CFC1 s E&P CFC 1 $70 PTI Account $30 E&P Actual Transaction US Parent $150 Sale Price Deemed Transaction US Parent Sale of CFC1 Shares CFC 2 $60 PTI Account $20 E&P CFC2 Shares Contribution of CFC1 Shares $60 PTI of CFC2 distributed $20 E&P of CFC2 distributed $70 PTI of CFC1 distributed CFC 1 $70 PTI Account $30 E&P $150 Redemption CFC 2 $60 PTI Account $20 E&P Only $20 of deemed distribution currently taxable * Example does not address potential GRA consequences. * * * * * / / 37

38 SECTION 986(c)

39 SECTION 986(c) Background: CFCs must maintain earnings and profits in their functional currencies Section 989 Requires that actual or deemed dividends be translated when recognized Subpart F income is translated at the weighted average exchange rate for the taxable year Section 956 inclusions are translated at the spot rate on the last day of the U.S. Shareholder s taxable year Section 1248 deemed dividends are translated at the spot rate on the date included in income by a shareholder / / 39

40 SECTION 986(c) General Rule: a U.S. Shareholder must recognize exchange gain or loss on a distribution of PTI PTI is translated at the spot rate on the date of the distribution Character/Source: Gain or loss is treated as ordinary income or loss from the same source as the original income inclusion / / 40

41 SECTION 986(c) EXAMPLE Facts CFC earns 100 of subpart F income in Year 1 In Year 1, the exchange rate is 1:$1 U.S. Tax Consequences For Year 1, CFC has 100 of PTI in the (c)(2) category The dollar basis of the PTI account is $100 / / 41

42 SECTION 986(c) EXAMPLE Facts In Year 2, CFC distributes 100 to its U.S. Shareholder At the time of the distribution, the exchange rate is 1:$1.50 U.S. Tax Consequences The U.S. Shareholder must recognize the difference between the PTI distributed and its dollar basis in the PTI, $50 ($150 - $100) / / 42

43 SECTION 986(c) SECTION 959 PROP. REGS. Previously Taxed Earnings and Profits Accounts Default Rule: Foreign exchange gain/loss determined based on allocation rules Dollar Pooling Basis: Proposed regulations permit taxpayers to pool PTI and determine foreign exchange gain/loss on an aggregate basis / / 43

44 SECTION 986(c) EXAMPLE Facts In Year 1, CFC makes a 100 investment in U.S. Property In Year 1, the exchange rate is 1:$1 In Year 2, CFC earns 100 of subpart F income In Year 2, the exchange rate is 1:$1.20 U.S. Tax Consequences On a dollar basis, the PTI account for CFC consists of: $100 of PTI in the (c)(1) category $120 of PTI in the (c)(2) category On a pooled basis, the CFC s PTI account consists of $220 of PTI Note: As measured in CFC s functional currency, the PTI account consists of 200 / / 44

45 SECTION 986(c) EXAMPLE Facts CFC distributes 100 to its U.S. Shareholder in Year 3 In Year 3, the exchange rate is 1:$1.30 U.S. Tax Consequences The distribution is treated as coming from the (c)(1) category (dollar basis of $100) The U.S. Shareholder recognizes $30 of foreign exchange gain ($130 less $100) If the U.S. Shareholder were to make a dollar pooling basis election, it would only recognize $20 of foreign exchange gain ($130 less $110 [( 100/ 200) x $220]) / / 45

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