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Coordination of Sections 959, 316, and 312 Is a Priority

By: Carrie Brandon Elliot

 

The Tax Law Center at New York University and the American Bar Association Section of Taxation prioritize guidance on coordinating the rules in section 959 with the provisions in sections 316, 312, and 961. Section 959 excludes a corporation’s previously taxed earnings and profits (PTEP) from a shareholder’s gross income when distributed. Guidance on coordination of the exclusion with dividend treatment in section 316 and earnings and profits adjustments in section 312 is given priority by both organizations.

 

This type of guidance is included in the IRS’s 2021-2022 priority guidance plan, which gives preference to regs under sections 959 and 961 addressing PTEP under subpart F, citing Notice 2019-1, 2019-2 IRB 275.

 

The Tax Law Center assigns medium priority to clarifying the interaction of section 959 with general E&P and dividend rules. The interaction between the rules governing PTEP of a controlled foreign corporation in section 959 and the general rules governing corporate distributions in subchapter C raises coordination issues.

 

For example, section 959(c) provides that to determine whether a distribution is made out of PTEP, section 316(a)(2) (relating to current-year E&P), and then section 316(a)(1) (relating to accumulated E&P), is applied to three section 959(c) categories of a foreign corporation’s earnings — two related to PTEP, and one related to non-PTEP E&P. Section 316(a) defines a dividend as a distribution of property made by a corporation to its shareholders first out of current E&P (described in section 316(a)(2)) and then out of accumulated E&P (described in section 316(a)(1)).

 

According to the Tax Law Center, this rule could be interpreted in multiple ways, and it is not clear whether section 959(c) requires that each category be further divided between current and accumulated subcategories. In other words, section 316(a)(2), and then section 316(a)(1), could be applied to each section 959(c) category in turn before moving on to the next category. Alternatively, section 316(a)(2) could be applied to all three categories before section 316(a)(1) is applied to all three categories.

 

Also, Notice 2019-1 suggests a limited role for section 316 in determining PTEP distributions. Section 3.02 states that the reference to section 316 merely indicates that a distribution of PTEP requires E&P otherwise sufficient to support a dividend.

 

Separately, section 3.03 of Notice 2019-1 provides that a CFC’s current-year deficit in E&P does not affect the amount of its PTEP. This rule is consistent with Rev. Rul. 86-131, 1986-2 C.B. 135, which coordinates the general rules for reducing E&P on a distribution of property in section 312(a)(3) and reg. section 1.312-1(b) with the three section 959(c) categories. However, the notice does not reference Rev. Rul. 86-131.

 

Treasury and the IRS should publish the proposed regs announced in Notice 2019-1 and more explicitly address the interaction of section 959 with subchapter C.

 

Treasury and the IRS should clearly address the coordination of section 959(c) with section 316 through a discussion of which interpretations are rejected, how the interpretation that is adopted aligns with the introductory language in section 959(c), and how that interpretation relates to the “PTEP-first” approach reflected in the notice.

 

Also, the proposed regs should confirm the point illustrated by Rev. Rul. 86-131 that distributions of loss property do not reduce PTEP more than the fair market value of the property, and thus must reduce non-PTEP E&P to the extent of the loss.

 

The proposed regs should clarify that the interaction of section 959(a) and (b) with section 316 means PTEP can be distributed before earnings that generate the PTEP have been earned. They should also clarify that reductions to E&P under section 312(a)(3) are made to accumulated (rather than current) E&P, and accordingly do not affect current-year PTEP. When Treasury and the IRS publish these proposed regs, they should announce the intent to withdraw Rev. Rul. 86-131 upon finalization.

 

The ABA tax section assigns high priority to guidance under section 959 and related provisions (like the stock basis adjustment rules in section 961) that apply to foreign corporations with PTEP resulting from subpart F income, global intangible low-taxed income inclusions, and other earnings subject to current tax under various provisions of the Tax Cuts and Jobs Act. These include annual accounts, groups of PTEP, ordering of E&P upon distributions, and reclassification.

 

Further, it would be helpful for guidance to address the announcement in Notice 2019-1 of the intent to withdraw proposed regs published on August 29, 2006 (REG-121509-00), on the exclusion from gross income of PTEP and associated basis adjustments. Those proposed regs address the exclusion of CFC previously taxed income in prop. reg. section 1.959-1 to -4 and related basis adjustments in prop. reg. section 1.961-1 to -4. The TCJA created more categories of section 959(c)(2) PTEP that cross-reference section 951(a)(1)(A) subpart F income. These include section 245A(e)(2) hybrid dividends, section 951A(f)(1) GILTI inclusions, section 959(e) coordination with section 1248, section 964(e)(4) gains on the disposition of stock, and section 965(a) and (b)(4)(A) transition tax provisions.

 

Section 959

Section 959(a)-(f) excludes PTEP from the gross income of U.S. persons.

 

Paragraphs (a)(1)-(2) provide that the E&P of a foreign corporation attributable to amounts that are (or have been) included in the gross income of a U.S. shareholder under section 951(a) are not included again in the gross income of that U.S. shareholder when the E&P is:

  • distributed to the shareholder; or
  • would (but for section 959(a)) be included in the gross income of the shareholder under section 951(a)(1)(B) as an investment of earnings in U.S. property.

 

The exclusion applies to the U.S. shareholder and other U.S. persons that acquire a portion of the interest of the shareholder in the foreign corporation — but only to the extent of that portion, and subject to proof of the identity of the interest, directly or indirectly, through a chain of ownership described under section 958(a). The rules of section 959(c) apply to exclusions of E&P distributions and the rules of section 959(f) apply to exclusions of investments in U.S. property.

 

Paragraph (b) expands the exclusion to gross income of foreign subsidiaries. The E&P of a CFC attributable to amounts that are (or have been) included in the gross income of a U.S. shareholder under section 951(a) are not, when distributed through a chain of ownership described in section 958(a), included in the gross income of another CFC in the chain in applying section 951(a) to the other CFC.

 

The rule also applies to other U.S. shareholders that acquire a portion of the interest of the U.S. shareholder in the CFC, but only to the extent of that interest portion, and subject to proof of the interest’s identity.

 

Paragraphs (c)(1)-(3) provide rules for allocating distributions to E&P in applying section 959(a) and (b). Under section 959(c)(1), taxpayers apply section 316(a)(2) and then 316(a)(1) first to the aggregate of:

  • E&P attributable to amounts included in gross income under section 951(a)(1)(B) (or that would have been included except for paragraph (a)(2)); and
  • E&P attributable to amounts included in gross income under section 951(a)(1)(C) (or that would have been included except for paragraph (a)(3)).

 

Distributions are allocated between the above two categories of E&P proportionately based on the respective E&P amounts.

 

Under section 959(c)(2), taxpayers then apply section 316(a)(2) and (1) to E&P attributable to amounts included in gross income under section 951(a)(1)(A). This is reduced by amounts not included under section 951(a)(1)(B) or (C) because of the exclusions in section 959(a)(2) and (3). Finally, under section 959(c)(3), taxpayers apply section 316(a)(2) and (a)(1) to other (non-PTEP) E&P.

 

References to section 951(a)(1)(C) and (a)(3) are to those provisions in effect on the day before enactment of the Small Business Job Protection Act of 1996 (P.L. 104-188), which repealed those provisions. The date of enactment was August 20, 1996.

 

Paragraph (d) provides that distributions excluded from gross income under section 959(a) are treated as distributions that are not dividends, except that they immediately reduce E&P.

 

Paragraph (e) coordinates section 959 with amounts that have been previously taxed under section 1248. In applying section 959 and section 960(c), amounts included as a dividend under section 1248(a) or (f) in a person’s gross income are treated as included in gross income under section 951(a)(1)(A).

 

Paragraphs (f)(1)-(2) provide two additional allocation rules. Amounts that would be included under section 951(a)(1)(B) (determined without regard to the exclusion in section 959) are attributable first to earnings described in section 959(c)(2) and then to earnings described in section 959(c)(3). Also, actual distributions are taken into account before amounts that would be included under section 951(a)(1)(B) (again determined without regard to section 959).

 

Section 316

Section 316(a) and (b) defines dividend. Under section 316(a)(1)-(2), a dividend is a distribution of property made by a corporation to its shareholders:

  • out of its E&P accumulated after February 28, 1913; or
  • out of its E&P of the tax year (computed as of the close of the year without diminution because of any distributions made during the year), without regard to the amount of the E&P at the time the distribution was made.

 

Every distribution is made from the most recently accumulated E&P. To the extent that any distribution is treated as a distribution of property to which section 301 applies, it is treated as a distribution of property.

 

Section 316(b)(1)-(4) contains an assortment of limits on the dividend definition that apply to insurance company dividends, distributions by personal holding companies (PHCs), deficiency dividend distributions by regulated investment companies and real estate investment trusts, and distributions by RICs in excess of E&P.

 

Paragraph (b)(1) provides that the dividend definition in section 316(a) does not apply to dividends as used in subchapter L when referring to dividends of insurance companies paid to policyholders.

 

Paragraph (b)(2) provides that a dividend includes any distribution of property (whether or not it is a dividend as defined in section 316(a)) made by a PHC to its shareholders to the extent of its undistributed PHC income (determined under section 545 without regard to distributions).

 

The PHC rule applies to a corporation that is a PHC (as defined in section 542) for the year in which the distribution is made. It also applies to a corporation that is a PHC for the tax year in which the distribution is made under section 563(b) (relating to dividends paid after the close of the tax year), or under section 547 (relating to deficiency dividends).

 

A distribution of property by a PHC includes a distribution in complete liquidation occurring within 24 months after the adoption of a plan of liquidation, but only to the extent of the amounts distributed to distributees other than corporate shareholders; and only if the corporation designates those amounts as a dividend distribution and notifies distributees of that designation.

 

The distribution of property treatment does not exceed the sum of the distributees’ allocable share of the undistributed PHC income for the year, computed without regard to section 316(b)(2) or section 562(b).

 

Under paragraph (b)(3), “dividend” also includes any distribution of property (whether or not it is a dividend as defined in section 316(a)) by a RIC or REIT that constitutes a “deficiency dividend” as defined in section 860(f).

 

Under paragraph (b)(4), if a RIC has a tax year other than the calendar year, and the distributions by the company for the tax year exceed its current and accumulated E&P that may be used for the payment of dividends, the company’s current E&P is allocated first to distributions made during the portion of the tax year that precedes January 1.

 

Section 312

Section 312(a)-(o) (paragraphs (e) and (j) were repealed in 1984 and 2004, respectively) governs the effect of a distribution on a corporation’s E&P. The guidance includes:

  • a general rule for adjusting E&P upon distributions;
  • adjustments for distributions of appreciated property;
  • adjustments to E&P for liabilities secured by distributed property or assumed by a shareholder;
  • rules for distributions of stock and securities;
  • adjustments for gain or loss from property sales and tax-free transactions;
  • E&P adjustments for increases in FMV of property before March 1, 1913;
  • allocations to E&P for corporate separations and reorganizations under sections 355 and 368;
  • adjustments for the distribution of proceeds of a loan insured by the United States;
  • adjustments to E&P for depreciation;
  • the effect on E&P of income from the discharge of indebtedness;
  • a prohibition on E&P adjustments for interest paid on obligations that are not in registered form;
  • an assortment of adjustments to E&P to reflect gain or loss more accurately; and
  • a definition of original issue discount and issue price.

 

The general rule in paragraphs (a)(1)-(3) provides that, on the distribution of property by a corporation, its E&P is decreased by the sum of:

  • the amount of money distributed;
  • the principal amount of the corporation’s obligations distributed (or the aggregate issue price of obligations having OID); and
  • the adjusted basis of any other property distributed.

 

The decrease in E&P for the adjusted basis of distributed property in section 312(a)(3) is among the rules for which the Tax Law Center suggests guidance. Reg. section 1.312-1(b) clarifies that the adjustment provided in section 312(a)(3) for a distribution of property (other than money or its own obligations) is made notwithstanding that the property has appreciated or depreciated in value since acquisition. Reg. section 1.312-1(c) illustrates this rule with two examples.

 

Example 1 assumes a corporation distributes to its sole shareholder property with a FMV of $10,000 and a basis of $5,000. It has $12,500 in E&P. The reduction in E&P by reason of the distribution is $5,000. This is the E&P reduction even though the FMV of $10,000 is includible in the income of the shareholder (other than a corporation) as a dividend.

 

Example 2 assumes the same facts as in Example 1 except that the property has a basis of $15,000 and the E&P of the corporation is $20,000. The reduction in E&P is $15,000 even though only $10,000 is includible in the income of the shareholder as a dividend.

 

Paragraphs (b)(1)-(2) address distributions of appreciated property. On the distribution by a corporation of any property (other than an obligation of the corporation) having FMV that exceeds the adjusted basis:

  • the E&P of the corporation is increased by the amount of the excess; and
  • E&P is reduced by the FMV instead of the adjusted basis under section 312(a)(3).

 

The adjusted basis of any property is its adjusted basis as determined in computing E&P.

 

Rev. Rul. 86-131

Rev. Rul. 86-131 provides guidance on adjustments to a CFC’s E&P to reflect a distribution to its U.S. shareholder of loss property having a basis that exceeds its FMV. Domestic corporation P wholly owns CFC FX1. On December 31, 1983, FX1 purchases from an unrelated party in a taxable transaction all the outstanding shares of FX2, a CFC engaged in manufacturing. On July 1, 1985, the FMV of the FX2 stock is $50, and FX1’s adjusted basis in the stock is $100. On that day, FX1 distributes all the FX2 stock to P.

 

Rev. Rul. 86-131 has a concise description of how sections 316(a) and 959(c) operate. Section 316(a) provides that a dividend is any distribution of property made by a corporation to its shareholders out of its E&P. Section 959 provides rules for the application of section 316 to the E&P of a CFC.

 

To the extent that an actual distribution is attributable to E&P described in section 959(c)(1) and (2) that have previously been included in the gross income of a U.S. shareholder of a CFC, section 959(a) provides that these amounts are not included again in the gross income of the U.S. shareholder when distributed. Section 959(d) provides that these amounts are generally to be treated as distributions that are not dividends. Only those distributions attributable to section 959(c)(3) (non-PTEP) amounts constitute section 316 dividends.

 

In determining the extent to which distributions are attributable to PTEP, a distribution made by a foreign corporation is:

  • first, a distribution of E&P attributable to amounts previously included in a U.S. shareholder’s gross income under section 951(a)(1)(B) as an increase in earnings invested in U.S. property under section 956 (section 959(c)(1));
  • second, a distribution out of E&P attributable to amounts previously included in gross income of a U.S. shareholder under section 951(a)(1)(A) as subpart F income (section 959(c)(2)); and
  • third, a distribution out of other E&P not yet included in a U.S. shareholder’s income (section 959(c)(3)).

 

Section 312(a) provides that a corporation that makes a distribution must decrease its E&P by the sum of money, the principal amount of the corporation’s obligations, and the adjusted basis of distributed property.

 

Under reg. section 1.312-1(b), the reduction of E&P for the adjusted basis of other property as provided in section 312(a)(3) is made regardless of whether the property value has appreciated or depreciated. The distribution of FX2 stock to P by FX1 constitutes a distribution of other property within the meaning of section 312(a)(3). The total E&P of FX1 will be reduced (but not below zero) by the adjusted basis of the FX2 stock distributed to P under reg. section 1.312-1(b).

 

Because the section 959(c) components are intended to reflect the composition of the CFC’s total E&P, they must be reduced by the same amount as the E&P reduction under section 312(a)(3). However, under section 959(a), the section 959(c)(1) and (2) components are reduced by the amount of the dividend before application of section 959. The amount of the dividend under section 301(b)(1)(C) is generally the FMV of the property distributed. To ensure that the sum of the section 959(c) components will equal the CFC’s total E&P after the application of section 312(a)(3), the section 959(c)(3) (non-PTEP) component must be increased or decreased so that the total of the adjustments to the section 959(c) components equals the section 312(a)(3) E&P reduction.

 

Because FX1’s basis in the FX2 stock ($100) exceeds the stock’s FMV ($50), FX1 will reduce its section 959(c)(1) and (2) components of E&P by the FMV of the FX2 stock distributed to P and will reduce its section 959(c)(3) component by an amount equal to the difference between the adjusted basis of the FX2 stock and the amount used to reduce the section 959(c)(1) and (2) E&P components. The example of E&P adjustments shown in the table reflects the application of section 312(a)(3).

 

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Rev. Rul. 86-131 goes on to clarify that if the FMV of the property distributed to P had exceeded its adjusted basis, FX1 would have recognized gain in the amount of the property’s appreciation and increased its E&P by that amount. FX1’s E&P would have been reduced by the basis of the property distributed, as adjusted to reflect the gain recognized on the distribution. This amount would be applied first against the section 959(c)(1) and (2) previously taxed components (to the extent thereof) and any remainder applied against the section 959(c)(3) account.

 

The Rev. Rul. 86-131 holding is that following a distribution out of E&P by FX1 to P of FX2 stock, which had depreciated in value, FX1’s total E&P will be adjusted first by reducing the section 959(c)(1) component by the FMV of the property distributed; second by reducing the section 959(c)(2) component by any excess of the FMV of the distributed property over the total section 959(c)(1) component; and third by reducing the section 959(c)(3) component by the difference between the section 312(a)(3) E&P adjustment and the reductions in the section 959(c)(1) and (2) components to reflect the application of section 312(a)(3).

 

Notice 2019-1

Section 3.02 of Notice 2019-1 addresses the ordering of E&P upon distribution and is cited by the Tax Law Center and the ABA tax section. Section 959(c) provides that section 316(a)(2) (current E&P) and then section 316(a)(1) (accumulated E&P) apply first to section 959(c)(1) PTEP, then to section 959(c)(2) PTEP, and finally to section 959(c)(3) (non-PTEP) E&P. The reference to section 316 in section 959 indicates that a distribution of PTEP depends on the existence of E&P otherwise sufficient to support a dividend under section 316.

 

The forthcoming regs will clarify that a distribution will be a distribution of PTEP only to the extent it would have otherwise been a dividend under section 316. For example, if a foreign corporation has no current or accumulated E&P at the end of a tax year, a distribution from the corporation to a shareholder during the year will be a return of basis or treated as gain from the sale or exchange of property under section 301(c)(2) or (3), regardless of whether the shareholder has one or more annual PTEP accounts for the foreign corporation.

 

Under section 316, distributions are considered first as distributions from current E&P and then as distributions from the most recently accumulated E&P. As noted above, PTEP will be maintained in annual PTEP accounts. To facilitate the rule in section 959(c), which incorporates the ordering rule of section 316, the forthcoming regs will require a last-in, first-out approach to sourcing distributions from annual PTEP accounts (subject to a special priority rule for PTEP arising from the application of the transition tax in section 965).

 

Section 3.03 addresses deficits in E&P. The aggregate of the amounts of section 959(c)(1) PTEP, section 959(c)(2) PTEP, and section 959(c)(3) E&P of a foreign corporation must equal the total E&P of the corporation. The forthcoming regs under section 959 will provide that current E&P are first classified as section 959(c)(3) E&P and then section 959(c)(3) E&P are reclassified as section 959(c)(1) or (2) PTEP, as appropriate, in full, which may have the effect of creating or increasing a deficit in section 959(c)(3) E&P.

 

For example, in a case in which the portion of a U.S. shareholder’s GILTI inclusion amount allocated to a CFC under section 951A(f)(2) and prop. reg. section 1.951A-6(b)(2) exceeds the current E&P of the CFC, section 959(c)(3) E&P will first be increased by the CFC’s current E&P and then decreased by the entire amount of the portion of the GILTI inclusion amount allocated to the CFC, possibly below zero. Section 959(c)(2) PTEP will be increased by the same amount.

 

If a foreign corporation has a current-year deficit in E&P, that deficit will solely reduce its section 959(c)(3) E&P without affecting the amount of its section 959(c)(1) or (2) PTEP.

 

Suggested Guidance

Proposed regs should clarify how the three section 959(c) PTEP and non-PTEP components overlap with the section 316(a) accumulated and current E&P categories.

 

Proposed regs should clarify that a CFC’s current-year deficit in E&P does not affect its PTEP amounts and confirm that distributions of loss property do not reduce PTEP by more than the FMV of the property, which are consistent with the holding in Rev. Rul. 86-131.

Company Tax Notes
Category FREE CONTENT;ARTICLE / WHITEPAPER
Intended Audience CPA - small firm
CPA - medium firm
CPA - large firm
Published Date 10/03/2022

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