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The Taxation of offshore Accumulated Earnings Under Section 959

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The U.S. international reporting requirements for shareholders of Controlled Foreign Corporations or CFC have dramatically expanded in recent years, largely attributable to the enactment of the 2017 law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, which added several new categories of foreign income inclusions — including the transition tax under Sec. 965 and the global intangible low-tax income (GILTI) regime pursuant to Sec. 951A.

Generally, U.S. shareholders of a CFC are required to include as U.S. income: 1) their pro rata share of subpart F income under Internal Revenue Code Section 951(a) (such as passive income, and certain foreign sales and service income); 2) their pro rata share of CFC’s earnings from investments in U.S. property as defined in Internal Revenue Code Section 956; 3) after the enactment of the 2017 Tax Cuts and Jobs Act, other items of global intangible low-taxed income (“GILTI”) as defined in Internal Revenue Code Section 951A. The U.S. shareholder is taxed even if the CFC does not make an actual distribution to the shareholder.

For purposes here, a “U.S. shareholder” is a U.S. person who owns, or is considered as owning, 10% or more of the total voting power or stock value of the CFC (Sec. 951(b)).

Prior to the passing of the 2017 legislation, a U.S. shareholder, in general, could defer its offshore E&P indefinitely to the extent the CFC did not run afoul of the so-called U.S. anti-deferral regime that consisted then of the Subpart F income provisions under Sec. 952 and the investment in U.S. property provisions under Sec. 956. Thus, in the absence of an actual dividend distribution, a U.S. shareholder could defer its offshore E&P indefinitely, provided the U.S. anti-deferral rules were inapplicable.

Prior to the 2017 Tax Cuts and Jobs Act, a U.S. corporate shareholder could claim a credit for foreign tax deemed paid by the CFC, for any actual or constructive distribution to the shareholders from the CFC. The amount of the deemed foreign tax credit was based on multi-year “pool” of earnings and taxes. After the 2017 Tax cuts and Jobs act, and modified Internal Revenue code Section 960, a U.S. corporate shareholder can claim a deemed paid credit for foreign income taxes attributable to current year subpart F and GILTI inclusions. See IRC Section 960(a) and (b).

A U.S. shareholder was required to include in U.S. taxable income the earnings of a CFC related to Subpart F income, investment in U.S. property income, or actual dividend distributions paid to U.S. shareholders from E&P, the annual E&P balances of the CFC would need to be tracked to ensure the corresponding previously taxed earnings and profits (PTEP) were properly maintained so that the U.S. shareholder would avoid double taxation on the same item of income on future distributions from the CFC. Specifically, the U.S. shareholder would report the current-year and accumulated E&P or deficits of the CFC along with the corresponding PTEP accounts and non-previously taxed E&P on Schedule J, Accumulated Earnings & Profits (E&P) of Controlled Foreign Corporation, and Schedule P, Previously Taxed Earnings and Profits of U.S. Shareholder of Certain Foreign Corporations, both of IRS Form 5471Information Return of U.S. Persons With Respect To Certain Foreign Corporations.

The TCJA created an additional U.S. anti-deferral regime under Sec. 951A, commonly referred to as GILTI, which is intended to impose a minimum tax with respect to a U.S. shareholder’s foreign-source income earned in low-tax jurisdictions. GILTI was designed to prevent U.S. persons from shifting profits from the United States to low-tax jurisdictions by way of transferring intellectual property or other intangible proprietary assets offshore. With the enactment of GILTI and other similar global initiatives such as the European Union’s anti–tax avoidance directive (ATAD) and the Organisation for Economic Cooperation and Development’s base-erosion and profit-shifting (BEPS) initiatives, many taxpayers have discovered that the days of deferring meaningful amounts of offshore E&P from current U.S. taxation have come and gone. Accordingly, with the many ways by which E&P of a CFC can be included into U.S. taxable income of U.S. shareholders, the corresponding reporting for these inclusions and PTEP accounts on Form 5471 has grown much more intricate and integral, as discussed next.

Common Foreign Income Inclusions of US Shareholders

U.S. shareholders of a CFC typically must include in gross income each of the following:

Subpart F income: Under Sec. 952, Subpart F income generally includes a U.S. shareholder’s pro rata share of a CFC’s E&P attributable to the following income generating activities:

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■ Sec. 954 foreign base company income (FBCI), which comprises:

Sec. 954(a)(1) foreign personal holding company income (FPHCI): FPHCI represents the net passive income earned by a CFC. This type of Subpart F income typically includes items such as dividends, interest, royalties, rents, annuities, and certain currency/transaction gains.

Sec. 954(a)(2) foreign-based company sales income (FBCSI): FBCSI represents income derived by a CFC from a purchase or sale of personal property involving a related party in which the goods are manufactured and sold for use/consumption outside the CFC’s country of incorporation.

Sec. 954(a)(3) foreign-based company services income: This represents the service income earned by a CFC in connection with the specified services that are performed on behalf of a related party and outside the country in which the CFC is incorporated (see Sec. 954(e)).

Sec. 954(a)(1) foreign personal holding company income (FPHCI): FPHCI represents the net passive income earned by a CFC. This type of Subpart F income typically includes items such as dividends, interest, royalties, rents, annuities, and certain currency/transaction gains.

■ Sec. 953(a) insurance income, which is defined as any income that is attributable to issuing or the reinsuring of an insurance or annuity contract and that would be taxed under Subchapter L if it were the income of a domestic insurance company; and

■ Sec. 952(a)(3), which is certain income earned by a CFC as a person participating in a Sec. 999 international boycott.

Sec. 956 investment in U.S. property income: Under Sec. 956(a), U.S. shareholders of a CFC are required to include in gross income their pro rata share of the average quarterly amount of U.S. property held both directly and indirectly by the CFC. A Sec. 956 income inclusion is similar to Subpart F income in that it does not require a CFC to actually make a distribution out of its E&P to the U.S. shareholder for an income inclusion to occur, but rather, it is treated as a deemed dividend inclusion. The Sec. 956 anti-deferral regime is aimed at preventing the deferral of untaxed E&P in a CFC that is effectively repatriated to the United States in the form of investment in U.S. property, subjecting any amounts to taxation in the current year. Income inclusions by U.S. shareholders under Sec. 956 represent the CFC’s adjusted basis in the U.S. property, decreased by the liabilities attached to that property.

Like Subpart F income, Sec. 956 income is limited under Sec. 956(a)(2) to the applicable E&P of the CFC. Sec. 956 income does not apply to E&P that has already been taxed in the United States if those same earnings have already been included by a U.S. shareholder and taxed by the United States (PTEP), as described in Sec. 959(a). It is important to note that Sec. 956 is effectively inapplicable for CFCs that have U.S. shareholders that are C corporations.

The TCJA enacted the Sec. 951A GILTI rules, an anti-deferral tax regime intended to prevent U.S. shareholders in CFCs from shifting profits from the United States to low-tax jurisdictions through the transfer of mobile income from intangible property. Rather than explicitly identifying what intangible income is, the GILTI provisions approximate the intangible income of a CFC by assuming a 10% rate of return on the CFC’s tangible assets (see Sec. 951A(b)(2)), and any income in excess of that “normal return” on assets is effectively treated as intangible income.

GILTI rules require U.S. shareholders to evaluate the aggregate of their pro rata share of net income and losses from all CFCs to determine the “net tested income” amount that would be subject to U.S. taxation under Sec. 951A(c). A U.S. shareholder’s GILTI inclusion for the tax reporting year is the excess of the U.S. shareholder’s pro rata share of net CFC tested income of all CFCs that the U.S. shareholder owns, over its 10% normal return on its tangible assets.

Keep in mind that a U.S. shareholder’s net CFC tested income is its aggregate pro rata share of tested income from all of its CFCs minus the aggregate pro rata share of tested loss from all CFCs (but not less than zero). Net deemed tangible income return (net DTIR) is defined as 10% of the U.S. shareholder’s pro rata share of aggregate qualified business asset investment (QBAI) of its CFCs, less specified interest expense. A CFC’s QBAI is its average quarterly tax basis in depreciable tangible property used in a trade or business (tracked using the alternative depreciation system method) for the production of tested income (see Sec. 951A(d)). It is important to note that a U.S. shareholder’s GILTI inclusion is not Subpart F income, and, unlike Subpart F income, GILTI is not subject to a CFC’s E&P.

Other inclusions under Sec. 1248 and Sec. 245A: While less common, there are notable ways in which a U.S. shareholder may be required to include into U.S. taxable income the gain recognized on the sale of CFC stock that is recharacterized as dividend income. Specifically, Sec. 1248(a) states that if a U.S. shareholder sells or exchanges stock in a foreign corporation that was a CFC at any time during a five-year period ending on the date of the sale or exchange, then the gain recognized on the sale or exchange of the stock is partly or wholly recharacterized as a dividend to the extent of the E&P of the CFC stock sold. The amount recharacterized as a dividend is limited to the extent of the E&P of the CFC while the U.S. shareholder owned the CFC shares.

Sec. 245A(e) disallows the dividends-received deduction under Sec. 245A(a) for any hybrid dividend received by a U.S. shareholder of a CFC. Moreover, Sec. 245A(e) treats hybrid dividends between CFCs with a common U.S. shareholder as Subpart F income. Note that Sec. 245A(e) defines a “hybrid dividend” as an amount received from a CFC for which a deduction would be allowed under Sec. 245A(a) and for which the CFC received a deduction or other tax benefit in a foreign country. A common example of a hybrid dividend is a convertible preferred equity certificate (CPEC), which is a financial instrument used in connection with Luxembourg financing structures. For Luxembourg tax purposes, the CPEC is treated as debt, and, therefore, the payment is deductible for local country purposes. For U.S. tax purposes, the CPEC is treated as equity or dividend income and therefore would qualify for the Sec. 245A foreign dividends-received deduction. However, Sec. 245A(e) disallows the Sec. 245A deduction and treats the dividend as Subpart F income for U.S. tax purposes.

Using Schedules J and P in connection with foreign income inclusions

This discussion now turns to Schedules J and P of Form 5471. These forms are used to track the accumulated E&P as well as the PTEP of a CFC on a yearby- year basis. Incorrectly tracking the various types of E&P and PTEP generated by a CFC each year could have severe tax consequences to a taxpayer as certain events occur throughout the life of a CFC. E&P and PTEP are used in the classification of distributions from a CFC to U.S. shareholders as dividends, return of capital, and capital gains distributions, in accordance with the Sec. 301(c) ordering rules.

Additionally, on Dec. 14, 2018, the IRS released Notice 2019-1, which provided guidance on the treatment of PTEP and the ordering rules under Sec. 959. While Notice 2019-1 goes beyond the scope of this item, it is important to note that appropriately accounting for a CFC’s E&P and PTEP related to U.S. inclusions directly affects any and all subsequent distributions made out of a CFC and, ultimately, the taxable income of a U.S. shareholder.

Note that the descriptions and examples below refer to the December 2020 revised versions of Schedules J and P and the accompanying tax year 2021 Form 5471 instructions. The following discussion highlights how Schedules J and P are used with specific types of foreign income inclusions.

Subpart F: E&P amounts identified as inclusions to U.S. shareholders under Subpart F are calculated at the CFC level. Generally, income inclusions to U.S. shareholders under Subpart F require that E&P be reclassified to one of several columns related to tracking PTEP on Schedules J and P.

■ Schedule J:

CFC income identified as Subpart F income must be reclassified from post-2017 E&P not previously taxed (column (a) of the form) to column (e)(x), which represents PTEP attributable to Sec. 951(a)(1)(A) inclusions.

If it is identified that any income under Subpart F is also subject to Sec. 956 as income related to investments in U.S. property, any PTEP attributable to Sec. 951(a)(1)(A) inclusions would alternatively be reported in column (e)(iii) of the form rather than in column (e)(x).

■ Schedule P:

CFC income identified as Subpart F should be reported under Sec. 951(a)(1)(A) PTEP in column (j) of the form, which represents PTEP attributable to Sec. 951(a)(1)(A) inclusions under Subpart F.

If it is identified that any income under Subpart F is reclassified as Sec. 956 income as investments in U.S. property, any PTEP attributable to Sec. 951(a)(1)(A) inclusions would alternatively be reported in column (c) rather than column (j).

Sec. 956 income: E&P amounts identified as inclusions to U.S. shareholders under Sec. 956 CFC investments in U.S. property are calculated at the CFC level. Columns (e)(i) through (e)(v) and columns (a) through (e) of Schedules J and P, respectively, are used to track any PTEP related to inclusions under Sec. 956.

■ Schedules J and P:

Column (e)(i) and column (a):

■ Track PTEP originally attributable to inclusions under Sec. 965(a) transition tax and reclassified as investments in U.S. property (Sec. 959(c)(1)(A) amounts).

Column (e)(ii) and column (b):

■ E&P treated as PTEP under Sec. 965(b)(4)(A) of deferred foreign income corporations and reclassified as investments in U.S. property.

Column (e)(iii) and column (c) consist of three subgroups:

■ PTEP attributable to, or reclassified as, investments in U.S. property that would have been deferred if not for Sec. 956;

■ PTEP attributable to Subpart F income inclusions (not described in any other column) and reclassified as investments in U.S. property under Sec. 956; and

Column (e)(iv) and column (d):

■ PTEP originally attributable to inclusions under Sec. 951A GILTI and reclassified as investments in U.S. property under Sec. 965.

Column (e)(v) and column (e) consist of three subgroups:

■ PTEP attributable to hybrid dividends under Sec. 245A(e)(2) and reclassified as investments in U.S. property under Sec. 965;

■ PTEP attributable to Sec. 1248 amounts under Sec. 959(e) and reclassified as investments in U.S. property under Sec. 965; and

■ PTEP attributable to Sec. 1248 amounts from the gain on the sale of foreign corporation stock by a CFC and reclassified as investments in U.S. property.

To avoid double taxation, Internal Revenue Code Section 959 provides that previously taxed earnings and profits (“FTEP”) of a CFC are not taxed again when distributed to the U.S. shareholder.

Before the enactment of the 2017 Tax Cuts and Jobs Act, under Section 959(a), a distribution by a CFC out of the earnings and profits (“E&P”) that had been previously taxed income was referred to as (“PTI”). Section 959 established ordering rules to keep track of a CFC’s E&P and to prevent double taxation by dividing a CFC’s E&P into three categories, known as:

1. Section 959(c)(1) account, from a prior-year Section 956 inclusions (1) to E&P that were required in prior years to be included as investments in U.S. property);

2. Section 959(c)(2) account, from current or prior year subpart F income inclusions and gains under Section 1248 that would otherwise be treated as capital gain which must be reported as ordinary income;

3. Section 959(c)(3) accounts (other earnings and profits).

Under the 959 ordering rules, an actual distribution was treated as made first out of the Section 959(c)(1) account, then out of the Section 959(c)(2) account, and finally out of the Section 959(c)(3). Within each Section 959(c) account, PTI is considered distributed on a last-in, first-out (“LIFO”) basis.

Example:

DC, a domestic corporation, owns all the stock of FC, a foreign corporation that a CFC. During year 1, FC has subpart F income of $200, earnings and profits of $400 and pays an actual dividend of $100. Assume that FC pays no foreign taxes on its income. DC must include $200 in gross income as ordinary income under Section 951(a)(1)(A)(i). Under the ordering rules in Section 959(c), DC would exclude the actual dividend of $100 from gross income under Section 959, because the distribution represents earnings and profits attributable to amounts that DC previously included in income under Section 951(a). The actual dividend would reduce FC’s earnings and profits from $400 to $300.

Example:

USP, a U.S. corporation, owns 100 percent of CFC1, a CFC. CFC1 owns CFC2, another CFC. CFC2 has owned 100 percent of DC, a U.S. corporation, since year 1. CFC2 has an adjusted basis of $3 in its DC stock. CFC2 has E&P of $10 in year 1. During year 2, CFC1 earns subpart F income of $50 to USP on June 1; CFC2 makes a distribution of $6 to CFC1 on December 1.

Year 1.

CFC2’s ownership of shares in DC constitutes an investment in U.S. property under Section 956, giving USP a Section 956 inclusion to the extent of the lesser of 1) CFC2’s E&P or 2) the adjusted basis of CFC2 in DC stock, which is $3 in year 1. This 956 inclusion in year 1 becomes CFC2’s PTI in year 2 as a Section 959(c)(1) PTI.

Year 2.

Typically, under Section 959(f)(2) actual distributions during the year are taken into account before current year Section 956 inclusions. Therefore, $3 of the December 1, year 2, distribution of $6 from CFC2 to CFC1 should be treated as made out of PTI from the year 1 Section 956 inclusion, and the remaining $3 of that distribution should be excepted from subpart F income as per Section 954(c)(6). CFC’1 Section 959(c)(1) PTI account is increased to $3 (the year 1 Section 956 PTI), while CFC2’s Section 959(c)(1) PTI account is reduced to zero before considering the year 2 Section 956 inclusion. See Example in Section 956 and Subpart F Inclusions, Actual Distributions, and Previously Taxed Income, by Hui Yu, June 30, 2014.

The IRS in Notice 2019-01 (the “Notice”) announced it will withdraw its current regulations for Section 959 and issue new regulations. Not only will the IRS promulgate new regulations regarding Section 959, the terminology has changed regarding the distributions from a CFC.The terminology has changed regarding the distributions from a CFC. Prior to the issuance of the Notice, Section 959 referred to a distribution by a CFC out of E&P that have been included in the income of a U.S. shareholder as PTI. Going forward, the IRS will refer to previously taxed earnings and profits of a CFC as PTEP instead of PTI. The Notice consists of three parts. Section 3 of the Notice is divided into three subparts. These subparts are referred to as 3.01, 3.02, and 3.03.

Section 3.01 of the Notice states that the new regulations to Section 959 will be enacted to changes made by the 2017 Tax Cuts and Jobs Act and will include rules relating to:

1. The maintenance of PTEP in annual accounts and within certain groups;

2. The ordering of PTEP upon distribution and reclassification; and

3. The adjustments required when an income inclusion exceeds the E&P of a CFC.

The Notice goes on to say that existing PTEP regulations will need to be modified to reflect the additional types of Section 959(c)(2) PTEP created under the 2017 Tax Cuts and Jobs Act. This includes a PTEP for GILTI inclusions, and mandatory transition tax, among others. Each group of PTEP may be subject to different rules under Sections 960, 965(g), 245(e)(3), and 986(c). Furthermore, because Section 959(c)(2) PTEP may be reclassified as Section 959(c)(1) PTEP as a result of a Section 956 investment, similar groups for Section 959(c)(1) PTEP must be maintained in order to properly apply Sections 960, 965(g), 245(e)(3), and 986(c) when earnings are reclassified.

Section 3.01 of the Notice provides that future regulations are expected to provide that an annual PTEP account must be maintained for each CFC and each PTEP account must be segregated into the following 16 PTEP groups in each Section 904 separate limitation category or “basket.”

Section 959(c)(1) PTEP

1. Reclassified Section 965(a) PTEP

2. Reclassified Section 965(b) PTEP

3. Section 951(a)(1)(B) PTEP

4. Reclassified Section 951A PTEP

5. Reclassified Section 245A(e)(2) PTEP

6. Reclassified Section 959(e) PTEP

7. Reclassified Section 964(e)(4) PTEP

8. Reclassified Section 951(a)(1)(A) PTEP

9. Section Section 956A PTEP

Section 959(c)(2) PTEP

10. Section 965(a) PTEP

11. Section 965(b) PTEP

12. Section 951A PTEP

13. Section 245A(e)(2) PTEP

14. Section 959(e) PTEP

15. Section 964(e)(4) PTEP; and

16. Section 951(a)(1)9(A) PTEP

Section 3.01 of the Notice also specifies that future regulations will follow the following:

Once PTEP is assigned to a PTEP group within an annual PTEP account for the year of the income inclusion under Section 951(a)(1), or the year of application of Section 965(b)(4)(A), the PTEP will be maintained in an annual PTEP account with a year that corresponds to the year of the account from which the PTEP originated if PTEP is distributed or reclassified in a subsequent tax year. This means that CFC shareholders must maintain PTEP accounts (in some cases PTEP sub-accounts) for each year and those accounts will have to be maintained until it is exhausted. Section 3.01 of the Notice states that forthcoming regulations will provide the following:

To the extent a CFC has E&P in a PTEP group that is in more than one Section 904 category, any distribution out of that PTEP group is made pro rata out of the E&P in each Section 904 category.

Dollar basis must be tracked for each annual PTEP account, and, to the extent provided in the regulations, separately for each PTEP group within an annual account.

New Ordering of E&P Rules

Section 3.02 of the Notice states that forthcoming regulations will clarify the following:

A distribution will be a distribution of PTEP only to the extent it would have otherwise been a dividend under Section 316. As such, a CFC that does not have current or accumulated E&P would not be able to distribute PTEP, even if it has PTEP accounts.

Under Section 316, distributions are considered first as distributions from current E&P, to the extent thereof, and then as distributions from the most recently accumulated E&P, to the extent thereof. To facilitate the rule in Section 959(c), which incorporates the ordering rule of Section 316, the forthcoming regulations will require a LIFO approach to the sourcing of distributions from annual PTEP accounts, subject to special priority rules applicable the Section 965.

By reason of Section 965(b)(4)(A), Section 965(a) will receive priority when determining the group of PTEP from which a distribution is made. This priority will be integrated into the general ordering rule of Section 959(c)(2) PTEP.

Thus, starting with Section 959(c)(1) PTEP, under the forthcoming regulations, as an exception to the LIFO approach, distributions will be sourced first from reclassified Section 965(a) PTEP and then from reclassified Section 965(b) PTEP. Once those PTEP groups are exhausted, under the LIFO approach, distributions will be sourced pro rata from the remaining Section 959(c)(1) PTEP groups in each annual PTEP account, starting from the most recent annual account. Once the PTEP groups relating to section 959(c)(1) PTEP are exhausted, distributions will be sourced from Section 959(c)(2) PTEP. The forthcoming regulations will provide an exception to the LIFO approach, distributions will be sourced from the Section 965(a) PTEP and then Section 965(b) PTEP. Once those two PTEP groups are exhausted, under the LIFO approach, distributions will be sourced pro rata from the remaining Section 959(c)(2) PTEP groups in each annual PTEP account, starting from the most recent annual PTEP account. Finally, once all the PTEP groups have been exhausted, the remaining amount of any distribution will sourced from Section 959(c)(3) E&P.

Adjustments Due to Income Inclusion in Excess of Current Earnings and Profits

Unlike subpart F inclusions, GILTI inclusions are not limited by current year E&P limitation. In order to provide clarity regarding GILTI inclusions not being limited by E&P limitations. Section 3.03 of the Notice states that the forthcoming regulations under section 959 will provide that current E&P will be first classified as Section 959(c)(3) E&P and then Section 959(c)(3) E&P will be reclassified as Section 959(c)(1) PTEP or Section 959(c)(2) PTEP, as appropriate, in full, which may have the effect of creating or increasing a deficit in Section 959(c)(3). Thus, where a current year GILTI inclusion exceeds available Section 959(c)(3) E&P, that balance becomes negative in order to allow for the creation of the appropriate PTEP while maintaining the current total PTEP.

The rules discussed above are extraordinarily complex. Any U.S. shareholder of a CFC should consult with a qualified international tax professional should they have any questions regarding their U.S. tax compliance requirements.