United States: Treasury withdraws 2006 proposed Previously Taxed Earning and Profits regulations and airs a grievance

Tax news and developments November 2022

In brief

On 21 October 2022, Treasury formally withdrew the 2006 proposed regulations under sections 959 and 961, also known as 2006 proposed Previously Taxed Earning and Profits (PTEP) regulations. One’s initial reaction to this may be: This is not news-worthy of a newsletter. Treasury already announced its intent to withdraw the 2006 proposed PTEP regulations almost four years ago in Notice 2019-1. However, there is at least one interesting tidbit to glean from Treasury’s announcement.


In depth

The formal withdrawal does not provide any details about what may be included in the upcoming proposed PTEP regulations nor does it provide an update on the projected timing for the release of proposed PTEP regulations (Treasury officials have predicted proposed regulations in the first half of 2023). This begs the question: After all of this time, what prompted Treasury’s decision to formally withdraw the 2006 proposed PTEP regulations? The answer, most likely, is that Treasury wanted to deliver this statement:

"Those [2006 proposed PTEP regulations] were never finalized, never went into effect, and did not indicate that taxpayers could rely on them. Withdrawing the proposed regulations at this point will help prevent possible abuse or other misuse of them—such as inappropriate basis adjustments in certain stock acquisitions to which section 304(a)(1) applies—while the Treasury Department and the IRS continue to develop the new proposed regulations. The IRS may, where appropriate, challenge taxpayer positions giving rise to inappropriate results".

The above makes it sound as though Treasury’s true purpose for the formal withdrawal was to register its disapproval of transactions applying Prop. Reg. §1.961-4, which is one sentence long and provides:

"In the case of a stock acquisition described in section 304(a)(1) that is treated as a distribution of earnings and profits of a foreign acquiring corporation or a foreign issuing corporation or both, basis adjustments shall be made in accordance with the rules of [Reg.] §§ 1.961-1, 1.961-2, and 1.961-3".

Of more interest than the proposed regulation itself are the two examples provided in Prop. Reg. §1.961-4. The proposed regulation, and thus the examples too, deal with section 304(a)(1), brother-sister type section 304 transactions, when the deemed redemption that results is treated as a section 301 distribution (i.e., the seller is treated as contributing the stock of the issuing corporation to the acquiring corporation in exchange for deemed shares of the acquiring corporation in a section 351 transaction and the acquiring corporation is treated as redeeming the deemed shares in a dividend equivalent redemption). In the first example, a domestic subsidiary sells the stock of a CFC to a CFC owned by the domestic parent of the domestic subsidiary. Likely of more relevance to the above is the second example, in which a domestic corporation, DP, owns two CFC’s, FX and FY. FX sells all of the stock of a third CFC, FZ, to FY. Under section 304(a)(1), FX is treated as contributing FZ to FY in exchange for deemed shares of FY and FY is treated as redeeming its deemed shares for the amount paid by FY to FX for the shares of FZ. The redemption is treated as a dividend sourced from the E&P of FY and then from the E&P of FZ.

In the example, both FY and FZ have PTEP and the PTEP is deemed distributed to FX. Then, in keeping with the purpose of section 961, DP’s basis in FY is reduced by the amount of the PTEP treated as a dividend sourced from the PTEP of FY and FX’s basis is increased by the same amount (the amount of the deemed dividend sourced from FZ had no net effect on basis adjustments, because the PTEP stayed with FX under the facts of the example). It is unclear what is inappropriate about this result in some or all instances. Without going into too much detail, the result seems rather appropriate, as the section 304 deemed dividend is a dividend, and PTEP is distributed via a dividend. If the basis in the stock of FY was not adjusted down, such stock would have an arguably inflated basis that would then permit the acquiring corporation to make distributions of PTEP from downstream CFCs without triggering section 961(b)(2) and could shelter gain on an indirect sale of FZ to a third-party through a sale of FY. Likewise, if the basis of FX was not increased, FX would often have PTEP that, if distributed, would cause gain to be recognized under section 961(b)(2) (because the section 961(a) basis adjustment corresponding to the PTEP deemed distributed to FX remained in the stock of FY).

It sounds as though Treasury is unhappy with transactions similar to the following (using the same nomenclature as the above example). DP’s basis in the stock of FX is $100. The fair market value of the stock of FX is also USD 100. FX sells FZ to FY for USD 50, when FY has USD 50 of PTEP. Under Prop. Reg. §1.961-4, DP’s basis in FY is reduced by USD 50 and its basis in FX is increased by USD 50. There is no change in the value of FX (as it transferred stock worth USD 50 for USD 50), so DP now has a USD 50 built-in loss in the stock of FX. Treasury does not seem to like this result, but it is difficult to conceive of a logical alternative that is consistent with sections 959 and 961. Of course, this becomes an issue now, post-TCJA, when, as the result of GILTI, it is common for virtually all of a CFC’s E&P to be PTEP and when PTEP can be earned at the GILTI effective rate. In other words, PTEP resulting from income taxed at an effective US rate of 10.5% gives rise to PTEP that can translate into a loss that counts against income taxed at the full 21% US corporate rate.

If this is an issue, it certainly seems like one that Congress, not Treasury, should address, but, as has become commonplace, Treasury has viewed itself as having the role of “fixing” perceived TCJA “oversights,” but only when those “errors” result in a potential benefit to taxpayers. It is difficult to divine from this data point alone what Treasury may have in mind more broadly for forthcoming proposed PTEP regulations. However, from the repeated delays to the issuance of proposed regulations and from Treasury's disavowal of the 2006 proposed regulations, there are indications that forthcoming PTEP regulations are likely to be a fundamental rethinking of the PTEP rules.

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