Background

Sections 959 and 961 are longstanding Code provisions, included in the initial enactment of subpart F, that prevent CFC income/earnings included in the income of a US shareholder from being taxed twice. Specifically, section 959 prevents PTEP from being subject to tax when distributed, and section 961 increases basis in CFC stock (or property through which CFC stock is owned) to prevent a US shareholder from being taxed both on the earnings of its CFC and on gain related to the previosuly taxed, undistributed earnings of the CFC. For decades, regulations promulgated in the 1960s served these Code sections sufficiently. In 2006, Treasury and the IRS proposed (but never finalized) regulations ("2006 Proposed Regulations"), attempting to modernize the rules.

After the enactment of GILTI as part of the TCJA, Treasury renewed its interest in PTEP, owing to GILTI's tendency to create enormous amounts of PTEP and the addition of section 965 PTEP to the expanding section 959(c)(2) bucket. At the end of 2018, Treasury announced its intent to withdraw the 2006 Proposed Regulations in Notice 2019-1, which described rules for the maintenance of PTEP accounts.

Almost four years later, on October 21, 2022, Treasury formally withdrew the 2006 Proposed Regulations. We noted then that a withdrawal of proposed regulations after so many years was an unusual move on Treasury's part in our client alert, Treasury Withdraws 2006 Proposed Previously Taxed Earnings and Profits Regulations and Airs a Grievance. We considered that Treasury may attempt to "fix" perceived Congressional oversights (possibly even in favor of tapayers) by fundamentally rethinking PTEP guidance in the new Proposed PTEP Regulations. This appears to be what happened.

Proposed PTEP Regulations

On December 2, 2024, Treasury and the IRS published the Proposed PTEP Regulations, which are intended to spell out the fundamental mechanics of the PTEP system, but they would do so through an extensive, baroque array of accounting systems to track numerous adjustments to different types of PTEP in accounts at both the shareholder and foreign corporation levels. The complex rule system appears intended to address "longstanding issues under sections 959 and 961," as stated in the preamble, as well as the multiple layers of PTEP and associated foreign taxes resulting from the TCJA's introduction of section 965, GILTI and credits for foreign taxes "properly attributable" to different types of PTEP, together with its elimination of section 902 and the E&P and foreign tax credit pooling systems.

Under section 959, the proposed rules cover PTEP accounting, shareholder-level adjustments, distributions of PTEP, exclusion from gross income of section 956 amounts allocated to PTEP, allocation and apportionment of foreign taxes to PTEP, and general successor transactions. The proposed section 960 regulations provide additional rules for allocating and apportioning foreign taxes to PTEP distributions, as well as computing deemed paid foreign taxes under section 960(b). The proposed regulations under section 961 provide detail on the mechanics of basis adjustments upon increases and distributions of PTEP, as well as certain consequences on the triggering of gain on PTEP distributions and dispositions of CFC stock. The proposed rules also include rules for foreign exchange gain or loss under section 986 related to PTEP, treatment of PTEP under section 962 elections, and rules for consolidated groups.

While many issues and questions will undoubtedly emerge, a broad overview of the rules' coverage and a few salient points are summarized at a high level here:

• PTEP accounting. The proposed rules largely track what Notice 2019-1 previewed, and require separate accounts for annual layers of each PTEP group (ten total) or subgroup (two total) in each section 904 category, dollar basis pools, and PTEP foreign tax pools. These accounts must be maintained by every "covered shareholder," or US shareholder of a CFC that is not a domestic partnership. In addition, each foreign corporation would be required to maintain separate corporation-level accounts of its PTEP and PTEP tax pools with respect to each covered shareholder.
• Shareholder-level adjustments. The proposed rules clarify which events trigger adjustments to increase or decrease PTEP balances and, importantly, when during the foreign corporation's tax year those adjustments occur. Thus, taxpayers have welcome assurance (previewed in unpublished guidance last year) that a subpart F or GILTI inclusion for a taxable year triggers adjustments to PTEP and PTEP basis as of the beginning of that year. Adjustments also cover changes to dollar basis pools and PTEP tax pools.
• Distributions of PTEP. The Proposed PTEP Regulations provide step-by-step rules for determining whether and how much of a PTEP distribution would be excluded from each covered shareholder's income, LIFO ordering of annual layers and priority rules for PTEP groups and subgroups (similar to what Notice 2019-1 described).
• General successor transactions. The proposed rules list certain transactions that cause one covered shareholder to succeed to the PTEP of an acquired foreign corporation and provide the steps for determining PTEP that is eligible for succession, as well as the PTEP's dollar basis and associated foreign taxes. This section contains an interesting proposed rule that would apply to an intervening foreign owner that acquires stock of a foreign corporation from one or more covered shareholders, then sells that stock to a subsequent covered shareholder (a "deemed covered shareholder"). The successor covered shareholder would be required to reconstruct transactions that affected PTEP during the intervening foreign shareholder's ownership, to determine the amount and character of PTEP the successor inherits.
• PTEP basis adjustments. The proposed rules under section 961 provide clarity on the operation of basis adjustments by separating CFC stock potentially subject to a section 961 adjustment into three types of "property units"—a section 961(a) ownership unit (CFC stock owned directly by a US shareholder), a derivative ownership unit (generally, CFC stock a covered shareholder owns indirectly through one or more partnerships), or a section 961(c) ownership unit (generally, foreign corporation stock owned indirectly by a covered shareholder through one or more CFCs). Basis is increased or decreased with respect to the different property units under specific rules—importantly, the proposed rules on derivative ownership units address adjustments to foreign corporation stock owned through partnerships and how that basis gets ascribed both to the partner covered shareholders and the partnership itself.

The proposed rules on basis adjustments to section 961(c) ownership units are particularly interesting. Treasury takes the view that section 961(c) "indicates" that Congress intended regulations to provide adjustments "similar to those in section 961(b) with respect to PTEP received by a CFC and amounts in excess of section 961(c) basis." Thus, the proposed rules provide that lower-tier CFC-to-CFC PTEP distributions reduce stock basis and can trigger gain under section 961(b). The rules also would introduce a new concept to treat E&P generated on the sale of section 961(c) ownership units that is "covered" by section 961(c) basis as its own type of PTEP.

• Foreign Currency Gain or Loss. The Proposed PTEP Regulations address when and to what extent foreign currency gain or loss is triggered under section 986(c), exceptions to gain or loss recognition in certain situations, and basis adjustments for foreign currency gain or loss and for general successor transactions.
• Consolidated group rules. The Proposed PTEP Regulations generally treat a consolidated group as a single covered shareholder for the purpose of applying the exclusion from income rules under section 959. For the basis rules under section 961, members of a consolidated group are treated as separate entities with respect to section 961(a) basis (i.e., actual basis increases that only apply at the top-tier ownership level). With respect to section 961(c) basis and derivative basis, the proposed regulations generally go back to a single entity model, but contain rules intended to prevent shifting these basis items between consolidated group members.

The rules generally apply to taxable years of foreign corporations beginning on or after the date final regulations are published and to taxable years of persons for which such taxable years of foreign corporations are relevant. Certain exceptions apply to provisions that carry over from Notice 2019-1, which announced Treasury's intent to issue new proposed regulations. The Proposed PTEP Regulations also provide for an early application option for taxpayers who wish to apply the rules in their entirety to the years covered by Notice 2019-1.

Future tranches of proposed regulations will address issues involving nonrecognition transactions, redemptions, section 964(e) transactions, structures where CFCs are partners in a partnership, and issues addressed in Notice 2024-16 (as discussed in our client alert, Notice 2024-16 Confirms Inbound Basis Bump Under Section 961(c)).