Background

The basis adjustment rules under section 961 have confounded taxpayers and practitioners for decades due to a potential timing mismatch between increasing and decreasing adjusted basis when there is a midyear previously taxed earnings and profits distribution. This mismatch became more pressing after GILTI's introduction in 2017 and the corresponding increase in PTEP in CFCs around the world. With the specter of significant double taxation looming, a growing number of taxpayers have sought clarity on the timing issues in section 961.

Section 961 provides for basis adjustments in CFC stock. Section 961(a) operates to increase the basis of CFC stock by its PTEP—the amount already included in the US shareholder’s gross income under the subpart F and GILTI inclusion rules. Under Treas. Reg. § 1.961-1(a), the increase occurs “as of the last day in the taxable year of such corporation on which it is a [CFC].” Section 961(b)(1) operates to decrease the adjusted basis of CFC stock by the PTEP distributed from the CFC to the US shareholder. Under Treas. Reg. § 1.961-2(a)(1), the decrease occurs “as of the time” the US shareholder receives the distribution.

This timing gap creates significant questions for taxpayers. If a CFC generates tested income includible as GILTI during the same year it distributes funds to its US shareholder, the US shareholder may have insufficient basis in its CFC stock to cover the distribution. Section 961(b)(2) provides that any distribution of PTEP in excess of the US shareholder’s basis in the CFC stock is treated as a gain from the sale or exchange of property. Thus, if we read the regulations literally, a taxpayer could: (i) incur GILTI or subpart F income for the year; (ii) pay additional tax on distributed PTEP from a CFC due to insufficient basis in the CFC stock; and then (iii) have their basis increased in their CFC stock—to no avail—at the end of the taxable year. Read literally, section 961(a) acts like a firefighter who didn’t quite make it before the house burned down.

The IRS’s position

The IRS takes a rational approach to the PTEP timing issue in the AM consistent with its approach to the same issue in PLR 202304008 issued earlier this year. For purposes of calculating section 961(b)(2) gain for distributions of PTEP at any point during the taxable year, the basis in the CFC stock should be increased by the basis adjustment under section 961(a). The AM provides the following example illustrating this approach.

A US shareholder (“USP”) owns the only outstanding share of a foreign corporation (FS). Before Year 1, USP has an adjusted basis of $0 in its FS stock and FS has $0 of PTEP. During Year 1, FS has USD 100 of income includable in USP’s gross income under the subpart F and GILTI rules. USP includes this income in its gross income and increases its PTEP account with respect to FS accordingly. Halfway through Year 1, FS distributes USD 100 to USP. Because USP already included USD 100 of FS’s E&P in its gross income, USP will not include the midyear distribution in its gross income under section 959(a). However, under 961(b), USP could face a tax on the amount distributed in excess of USP’s basis in the FS stock. If the government considers the adjusted basis to be USD 0, then USP would be taxed as though all USD 100 were gain from the sale or exchange of property.

The IRS avoids this result by taking into account the increase in adjusted basis under section 961(a) at the time of the PTEP distribution for the purpose of calculating any gain under 961(b)(2). USP therefore increases its adjusted basis in its FS stock to USD 100 before the decrease under section 961(b) and does not recognize any gain on the USD 100 distribution of PTEP. At the end of Year 1, USP has a USD 0 adjusted basis in FS stock reflecting the USD 100 increase under section 961(a) and the USD 100 decrease under section 961(b)(1).

The IRS's reasoning

The IRS bases its conclusion on the policies of sections 959 and 961 to prevent double taxation. Section 959 aims at this goal by excluding PTEP from a US shareholder’s gross income during distribution. Section 961 follows suit by adjusting the basis in CFC stock up or down based on the existence or distribution of PTEP, with the idea that gain on the sale of CFC stock should reflect any retained earnings already taxed to the US shareholder. These are “companion provisions” with the “common purpose of preventing double taxation”—denying a taxpayer basis adjustments accounting for PTEP created during the taxable year until the last day of the taxable year would undermine this goal.

The AM also stated that denying basis adjustments midyear would produce “discordance” between these same code sections. Section 959(c) allows the full amount of PTEP for distributions at any time during the year. A strict interpretation of the regulations would prevent the same clemency for calculating section 961(b)(2) gain. The IRS notes that neither section 961(b)(2) nor Treas. Reg. § 1.961-2(c) specifically address midyear distributions. In light of these facts, the IRS finds that the “better interpretation” of the PTEP rules and regulations is to take into account the increase in basis at the time of the PTEP distribution when applying section 961(b)(2).

Conclusion

The AM presents a straightforward solution to a timing problem that has vexed taxpayers for years. While not precedential, the AM (and earlier issued PLR 202304008) suggests how the IRS may address this issue in future regulations. It remains to be seen whether the IRS will meet its previously stated goal of issuing proposed PTEP regulations during the first half of this year, but the AM is welcome guidance in the meantime.