SECTION 959
PREVIOUSLY TAXED
INCOME OF A CFC
John Robert Cohn, Partner
Thompson & Knight LLP
Dallas, Texas
U.S. TAX PLANNING FOR CFCs UNDER SUBPART F
You’ve picked up a subpart F inclusion –
now what do you do?
You receive a distribution –
am I taxed again?
OVERVIEW
• Section 959
 General Operating Rules
 Consequences of PTI Distributions
 Successor Rules
• Proposed Regulations
• Section 986(c)
// 3
SECTION 959
SECTION 959 – GENERAL OPERATING RULES
• General Rule: Previously taxed earnings and profits (“PTI”) are not
subject to U.S. tax when distributed
 Purpose: To prevent double taxation of amounts already subject to U.S. tax
• Requirements: Earnings and profits must have been included in the
gross income of a U.S. Shareholder (sec. 951(b))
 “Shareholder level” attribute
 Earnings and profits attributable to shares held by foreign persons and less
than 10% domestic shareholders not eligible for PTI treatment
// 5
SECTION 959 – GENERAL OPERATING RULES
What types of income create PTI?
 Subpart F Income
 Increases in Earnings Invested in U.S. Property (i.e., section 956
inclusions)
 E&P subject to taxation under section 1248
 Previously Excluded Subpart F Income Withdrawn from Investment
in Less Developed Countries (pre-’75 Subpart F income)
 Previously Excluded Subpart F Income Withdrawn from Investment
in Foreign Base Company Shipping Operations (pre-’87 Subpart F
income)
// 6
SECTION 959 – GENERAL OPERATING RULES
General Operating Rules
• Payment to a U.S. Shareholder (or successor) must be characterized
as a “distribution” for U.S. tax purposes
 Actual distributions
 Distributions under section 302 (i.e., redemptions) characterized as
dividends under section 301
 Certain deemed distributions
 Includes section 304 distributions
 Certain transfers characterized as distributions under foreign law
may not give rise to PTI
• e.g., loans treated as constructive distributions under foreign law
• E&P deficits do not prevent PTI distributions
// 7
SECTION 959
General operating rules (cont.)
• Recipient does not need to be a U.S. Shareholder of the distributing
foreign corporation at the time of distribution
 See successor rules (below)
• Distributing foreign corporation does not need to be a CFC at the time
of distribution
// 8
SECTION 959 – GENERAL OPERATING RULES
Consequences of a PTI distribution
 Not treated as a dividend
• Exceptions:
> Treated as a dividend for purposes of determining the credit
available for foreign taxes paid with respect to a distribution of
foreign taxes
> Treated as a dividend for section 1411 (the 3.8% Medicare tax)
 Adjustments to PTI Accounts
• Reduction in PTI accounts of distributing foreign corporation
• Increase in PTI accounts of recipient foreign corporation
• Proposed Regulations adopt PTI leveling concept where U.S.
Shareholder holders multiple blocks of stock
// 9
SECTION 959 - DISTRIBUTIONS
Facts – Current Year Distribution
• CFC earns $100 subpart F income in Year 1
• CFC’s current and accumulated E&P (before distributions)
is $150
• CFC makes $50 distribution to US Parent in Year 1
$100
US Tax Consequences
Subpart F Inclusion
• US Parent includes $100 in income as a subpart F
inclusion in Year 1
• US Parent is not taxed on receipt of $50 distribution in Year
$100
1 under section 959
Subpart F Income
US
Parent
$50
Distribution
CFC
* * * * *
Facts - Subsequent Year Distribution
* Facts assume E&P in excess of subpart F amounts.
• CFC earns $100 subpart F income in Year 1
• CFC’s current and accumulated E&P (before distributions)
is $150
• CFC makes $50 distribution to US Parent in Year 2
US Tax Consequences
• US Parent includes $100 in income as a subpart F
inclusion in Year 1
• US Parent is not taxed on receipt of $50 distribution in Year
2 under section 959
/ / 10
SECTION 959 – SECTION 956 INCLUSIONS
Facts – Current Year Distribution
• CFC earns $100 subpart F income in Year 1
• CFC invests $50 in U.S. Property in Year 1
US Tax Consequences
• US Parent includes $100 in income as a subpart F
inclusion in Year 1
• CFC’s investment in U.S. Property does not result in a
section 956 inclusion
* * * * *
Facts - Subsequent Year Distribution
• Same as above, except that CFC makes investment in U.S.
Property in Year 2
US Tax Consequences
• Same as above – i.e., investment in U.S. property does not
result in section 956 inclusion
$100
Subpart F Inclusion
$100
Subpart F Income
US
Parent
CFC
$50
Investment in
US Property
US
Property
* Facts assume E&P in excess of subpart F amounts.
/ / 11
SECTION 959 – TIERED DISTRIBUTIONS
Tiered Distributions
• Similar PTI treatment applies to distributions between
CFCs
• An upper-tier CFC that receives a distribution of PTI from
a lower-tier CFC is not required to include the distribution
in income
• Recipient CFC accounts for the PTI in the same manner
(i.e., category and year) as the distributing CFC
(discussed below)
/ / 12
SECTION 959 – TIERED DISTRIBUTIONS
Facts – Current Year Distribution
• CFC3 earns $100 subpart F income in Year 1
• CFC3 makes $50 distribution to CFC2 in Year 1
• CFC2 makes $50 distribution to CFC1 in Year 1
• CFC1 makes $50 distribution to US Parent in Year 1
$100
Subpart F Inclusion
US Tax Consequences
• US Parent includes $100 in income as a subpart F inclusion
in Year 1
• Distribution from CFC3 to CFC2 is not treated as income to
CFC2
• Distribution from CFC2 to CFC1 is not treated as income to
CFC1
• US Parent is not taxed on receipt of $50 distribution from
$100
CFC1
Subpart F Income
US
Parent
$50
Distribution
CFC 1
CFC 2
CFC 3
$50
Distribution
$50
Distribution
* * * * *
Facts - Subsequent Year Distribution
• Same as above, except distributions are not made until Year
2
* Facts assume E&P in excess of subpart F amounts.
US Tax Consequences
• Same as above – i.e., distributions of PTI are not included in
income
/ / 13
SECTION 959 – TIERED DISTRIBUTIONS
Facts – Current Year Distribution
• CFC3 earns $100 subpart F income in Year 1
• CFC3 distributes $50 to CFC2 in Year 1
• CFC2 invests $50 in U.S. Property in Year 1
US Tax Consequences
• US Parent includes $100 in income as a subpart F
inclusion in Year 1
• CFC2 does not include distribution in gross income
• CFC2’s investment in U.S. Property does not result in
a section 956 inclusion
* * * * *
Facts - Subsequent Year Distribution
• Same as above, except that CFC2 makes investment
in U.S. Property in Year 2
US Tax Consequences
• Same as above – i.e., investment in U.S. property
does not result in section 956 inclusion
US
Parent
$100
Subpart F Inclusion
CFC 1
CFC 2
$50
Distribution
$100
Subpart F Income
CFC 3
$50
Investment in
US Property
US
Property
* Facts assume E&P in excess of subpart F amounts.
/ / 14
SECTION 959 – ALLOCATIONS
General Rules
 Ordering Rules
• (c)(1) – 956 Inclusions
• (c)(2) – Subpart F Income
• Reduced by amounts invested in U.S. Property
• (c)(3) – Non-Previously Taxed Earnings
 LIFO approach
 Lower-tier CFC earnings distributed before upper-tier CFC earnings
/ / 15
SECTION 959 – ALLOCATIONS
Demonstrating the ordering rules
• Sec. 956 → Subpart F → Other
• LIFO
Amount
Year
Allocation
100
Year 2
(c)(1)
50
Year 1
(c)(1)
50
Year 1
(c)(1)
75
Year 3
(c)(2)
25
Year 2
(c)(2)
50
Year 2
(c)(2)
50
Year 4
(c)(3)
50
Year 3
(c)(3)
Distribution #1 - $150
150
US
Parent
$150
Distribution
(x3)
CFC
Distribution #2 - $150
150
Year
1
(c)(1) - 956
100
(c)(2) – Subpart F
2
100
75
3
4
75
(c)(3) - Other
50
50
Distribution #3 - $150
150
/ / 16
SECTION 959 – ALLOCATIONS
Distributions between CFCs
 Allocated to the same category of the distributing CFC
 Allocated to the same year in which incurred by the distributing CFC
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SECTION 959 – ALLOCATIONS
CFC 2 – Pre-Distribution
Year
1
(c)(1)
50
(c)(2)
2
75
3
75
CFC 1 – Pre-Distribution
(c)(3)
US
Parent
50
CFC1
4
50
$150
Distribution
Year
1
(c)(1)
100
(c)(2)
2
100
75
3
75
4
(c)(3)
50
50
CFC2
CFC 2 – Post-Distribution
Year
1
2
3
4
(c)(1)
0
(50-50)
(c)(2)
50
(75-25)
0
(75-75)
CFC 1 – Post-Distribution
(c)(3)
Year
1
2
50
3
50
4
(c)(1)
150
(100+50)
(c)(2)
100
(75+25)
150
(75+75)
(c)(3)
50
50
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SECTION 959 – FOREIGN TAXES
FACTS – YEAR 1
• CFC2 earns $150 subpart F income in Year 1
US
Parent
US TAX CONSEQUENCES
• US Parent includes $150 in income as a subpart F inclusion
in Year 1
• CFC2 has $150 of PTI in the (c)(2) category
* * * * *
FACTS – YEAR 2
• CFC2 distributes $150 to CFC1 in Year 2
 Distribution is subject to $20 of withholding tax in CFC2’s
country of incorporation
CFC1
$150
Distribution
CFC2
$10
Foreign Tax
$20
Withholding Tax
Net Distribution of $120
 CFC1 is subject to $10 of foreign tax upon receipt of the
distribution in its country of incorporation
US TAX CONSEQUENCES
• CFC2 reduces its PTI account for the (c)(2) category from
$150 to $0
• CFC1 increases its (c)(2) account by $120 ($150 net of $20
withholding tax and $10 of foreign income tax)
/ / 19
SECTION 959 – SUCCESSORS
Successors to U.S. Shareholders that previously
included CFC earnings and profits in gross income
may exclude distributions of PTI from gross
income.
Successor treatment applies to
purchases/acquisitions of CFC shares from:
 U.S. Shareholders
 U.S./non-U.S. persons that acquired CFC
shares from U.S. Shareholder
 Upper-tier CFCs (e.g., a purchase of CFC3
shares from CFC2)
US
Parent
US
Person
Foreign
Person
CFC 1
CFC 2
CFC 3
/ / 20
SECTION 959 – SUCCESSORS
Information required to be furnished:
1. Identity of distributing foreign corporation
2. Identify of person from whom interest in distributing foreign
corporation was acquired
3. Description of interest in distributing foreign corporation
4. Amount of exclusion being claimed under section 959
5. Evidence showing that the E&P for which an exclusion is being
claimed
 Has been included in the gross income of a U.S. Shareholder
 Has not been previously excluded from the gross income of a
U.S. Person
/ / 21
PROPOSED
REGULATIONS (2006)
SECTION 959 - PROPOSED REGULATIONS
Effective date:
 The proposed regulations would apply to tax years of foreign corporations
beginning on or after the date they are published as final, and tax years of
U.S. shareholders with or within which such tax years of foreign
corporations end.
 After these regulations become effective, foreign corporations and
shareholders who are currently accounting for PTI in a manner other than
that which is provided in these regulations may use any reasonable
method to conform their current accounting of PTI to the rules provided in
these regulations.
/ / 23
SECTION 959 – PROPOSED REGULATIONS
Overview
 Previously Taxed Earnings and Profits Accounts
 Multiple Blocks of Stock
 Consolidated Groups
 Split Ownership Issues
 Section 304 Transactions
/ / 24
SECTION 959 - PROPOSED REGULATIONS
Previously Taxed Earnings and Profits Accounts
 Shareholder-level accounts
•
Account must be maintained for each share in the functional currency of
the foreign corporation
> May elect to maintain accounts on dollar pooling basis (discussed
below)
•
Accounts may be maintained on a block basis
•
Accounts remain in existence even if shares held by non-U.S. persons
 Corporate-level account
/ / 25
SECTION 959 - PROPOSED REGULATIONS
Previously Taxed Earnings and Profits Accounts (cont.)
 Foreign taxes paid with respect to distributions of PTI maintained in
account separate from post-1986 foreign income taxes
• Foreign taxes deemed paid when PTI distributed
/ / 26
SECTION 959 - PROPOSED REGULATIONS
Multiple Blocks of Stock
• Premise:
 A U.S. Shareholder holds multiple blocks of CFC stock with varying
PTI account balances
 CFC makes a distribution which exceeds the PTI balance for some
shares (low-PTI shares), but not for others (high-PTI shares)
• Proposed Regulations
 PTI from high-PTI shares reallocated to low-PTI shares
• Compare with Unified Loss Rules in consolidated return
regulations (basis leveling)
/ / 27
SECTION 959 - PROPOSED REGULATIONS
Example – Multiple Blocks of Stock
• With respect to CFC, U.S. Shareholder has
 one share (Share 1) of stock with $50 of PTI in category (c)(2)
 one share (Share 2) of stock with $200 of PTI in category (c)(2)
• CFC has total E&P in excess of $200
• CFC distributes $100 with respect to each share
/ / 28
SECTION 959 - PROPOSED REGULATIONS
Under current regulations:
 Distribution with respect to Share 1 results in
• A distribution of $50 of PTI and $50 of non-previously taxed E&P
• Category (c)(2) account reduced to zero ($50 - $50)
 Distribution with respect to Share 2 results in
• A distribution of $100 of PTI
• Category (c)(2) account reduced to $100 ($200 - $100)
/ / 29
SECTION 959 - PROPOSED REGULATIONS
Under proposed regulations:
 PTI Leveling
• PTI account for Share 2 reduced by $50
• PTI account for Share 1 increased by $50
 Distribution with respect to Share 1 results in
• A distribution of $100 of PTI ($50 Share 1; $50 Share 2)
• Category (c)(2) account reduced to zero ($50 +$50 - $50 - $50)
 Distribution with respect to Share 2 results in
• A distribution of $100 of PTI
• Category (c)(2) account reduced to $50 ($200 - $100 - $50)
/ / 30
SECTION 959 - PROPOSED REGULATIONS
Consolidated Groups
• Premise:
 U.S. Shareholders belong to a U.S. consolidated group
 Consolidated group members hold CFC stock with varying PTI account
balances
 CFC makes a distribution which exceeds the PTI balance for some
members shares (low-PTI shares), but not for others (high-PTI shares)
• Proposed Regulations
 Adopts rule for consolidated groups similar to PTI-leveling rule for multiple
blocks of stock
 PTI from high-PTI shares reallocated to low-PTI shares
 Consolidated group rule only applies after PTI-leveling rule for multiple
stock blocks
/ / 31
SECTION 959 - PROPOSED REGULATIONS
Example – Consolidated Groups
• Consolidated group member (Member 1) holds one share of CFC
stock with $50 of PTI in category (c)(2)
• Another consolidated group member (Member 2) holds one share of
CFC stock with $200 of PTI in category (c)(2)
• CFC has total E&P in excess of $200
• CFC distributes $100 to each of Member 1 and Member 2
/ / 32
SECTION 959 - PROPOSED REGULATIONS
Under current regulations:
 Result is similar to example above
 Distribution with respect to Member 1 results in
• A distribution of $50 of PTI and $50 of non-previously taxed E&P
• Category (c)(2) account reduced to zero ($50 - $50)
 Distribution with respect to Member 2 results in
• A distribution of $100 of PTI
• Category (c)(2) account reduced to $100 ($200 - $100)
/ / 33
SECTION 959 - PROPOSED REGULATIONS
Under proposed regulations:
 PTI Leveling
• PTI account for Member 2 reduced by $50
• PTI account for Member 1 increased by $50
 Distribution with respect to Member 1 results in
• A distribution of $100 of PTI ($50 Share 1; $50 Share 2)
• Category (c)(2) account reduced to zero ($50 +$50 - $50 - $50)
 Distribution with respect to Member 2 results in
• A distribution of $100 of PTI
• Category (c)(2) account reduced to $50 ($200 - $100 - $50)
/ / 34
SECTION 959 – PROPOSED REGULATIONS
Facts – Current Year Distribution
• CFC2 earns $100 subpart F income in Year 1
• CFC2 distributes $100 to CFC1 in Year 1
US Tax Consequences
• US Parent includes $70 (pro rata share) in
income as a subpart F inclusion in Year 1
• Regulations clarify that CFC1 does not
include any portion of distribution in gross
income – i.e., exclusion not limited to $70 that
US Parent included in gross income
* * * * *
US
Parent
$70
Subpart F Inclusion
Foreign
Shareholder
70%
30%
CFC 1
$100
Distribution
$100
Subpart F Income
CFC 2
* Facts assume E&P in excess of subpart F amounts.
/ / 35
SECTION 959 – PROPOSED REGULATIONS
Facts – Current Year Distribution
• CFC2 earns $100 subpart F income in Year 1
• Foreign Shareholder sells 30% interest in CFC1 to
US Person in Year 2
• CFC2 distributes $100 to CFC1 in Year 2
US Tax Consequences
• US Parent includes $70 (pro rata share) in income
as a subpart F inclusion in Year 1
• As above, CFC1 does not include any portion of
distribution in gross income – i.e., exclusion not
limited to $70 that US Parent included in gross
income
• US Parent has $70 PTI balance with respect to
CFC 1
• For purposes of determining subpart F
consequences for US person, distribution from
CFC2 to CFC1 not excluded from CFC1’s gross
income because no amounts have been previously
included in the income of US person with respect to
those shares
 US Person includes $30 in gross income as a
subpart F inclusion
 US Person has a $30 PTI account balance with
respect to CFC1
* * * * *
Year 1 Transactions
$70
Subpart F Inclusion
US
Parent
Foreign
Shareholder
70%
30%
CFC 1
CFC 2
$100
Subpart F Income
Year 2 Transactions
$70 PTI
Account (CFC2)
US
Parent
Foreign
Shareholder
70%
Sale
US
Person
30%
CFC 1
$100
Distribution
CFC 2
* Facts assume E&P in excess of subpart F amounts.
/ / 36
SECTION 959 – PROPOSED REGULATIONS
Facts – Current Year Distribution
• US Parent sells CFC1 shares to CFC2 for $150
Recast Under Section 304
• US Parent makes a deemed contribution of the shares of
CFC1 to CFC2 under section 351 transaction in exchange
for deemed shares of CFC2
• US Parent is deemed to redeem the deemed shares of
CFC2 issued in the initial contribution
US Tax Consequences of Recast Transaction
• US Parent and CFC2 do not recognize gain in connection
with the deemed section 351 exchange
• Deemed redemption of CFC2 shares by US Parent is
treated as a section 301 distribution
• Distribution is characterized a “dividend” to the extent of
CFC2’s E&P and, if necessary, CFC1’s E&P
 $60 PTI of CFC2 distributed
 $20 E&P of CFC2 distributed
 $70 PTI of CFC1 distributed
 Only $20 of deemed distribution currently taxable
Actual Transaction
Sale of
CFC1 Shares
US
Parent
CFC 1
CFC 2
$150
Sale Price
$70 PTI Account
$30 E&P
$60 PTI Account
$20 E&P
Deemed Transaction
US
Parent
CFC 1
$70 PTI Account
$30 E&P
$150
Redemption
Contribution of
CFC1 Shares
CFC2 Shares
CFC 2
$60 PTI Account
$20 E&P
* Example does not address potential GRA consequences.
* * * * *
/ / 37
SECTION 986(c)
SECTION 986(c)
Background: CFCs must maintain earnings and profits in their functional
currencies
Section 989 – Requires that actual or deemed dividends be translated
when recognized
 Subpart F income is translated at the weighted average exchange rate for
the taxable year
 Section 956 inclusions are translated at the spot rate on the last day of the
U.S. Shareholder’s taxable year
 Section 1248 deemed dividends are translated at the spot rate on the date
included in income by a shareholder
/ / 39
SECTION 986(c)
General Rule: a U.S. Shareholder must recognize exchange
gain or loss on a distribution of PTI
 PTI is translated at the spot rate on the date of the
distribution
Character/Source: Gain or loss is treated as ordinary income
or loss from the same source as the original income
inclusion
/ / 40
SECTION 986(c) – EXAMPLE
Facts
• CFC earns €100 of subpart F income in Year 1
• In Year 1, the exchange rate is €1:$1
U.S. Tax Consequences
• For Year 1, CFC has €100 of PTI in the (c)(2) category
• The dollar basis of the PTI account is $100
/ / 41
SECTION 986(c) – EXAMPLE
Facts
• In Year 2, CFC distributes €100 to its U.S. Shareholder
• At the time of the distribution, the exchange rate is €1:$1.50
U.S. Tax Consequences
• The U.S. Shareholder must recognize the difference between the
PTI distributed and its dollar basis in the PTI, $50 ($150 - $100)
–
/ / 42
SECTION 986(c) – SECTION 959 PROP. REGS.
Previously Taxed Earnings and Profits Accounts
• Default Rule: Foreign exchange gain/loss determined
based on allocation rules
• Dollar Pooling Basis: Proposed regulations permit
taxpayers to pool PTI and determine foreign exchange
gain/loss on an aggregate basis
–
/ / 43
SECTION 986(c) – EXAMPLE
Facts
• In Year 1, CFC makes a €100 investment in U.S. Property
 In Year 1, the exchange rate is €1:$1
• In Year 2, CFC earns €100 of subpart F income
 In Year 2, the exchange rate is €1:$1.20
U.S. Tax Consequences
• On a dollar basis, the PTI account for CFC consists of:
 $100 of PTI in the (c)(1) category
 $120 of PTI in the (c)(2) category
• On a pooled basis, the CFC’s PTI account consists of $220 of PTI
 Note: As measured in CFC’s functional currency, the PTI account
consists of €200
/ / 44
SECTION 986(c) – EXAMPLE
Facts
• CFC distributes €100 to its U.S. Shareholder in Year 3
 In Year 3, the exchange rate is €1:$1.30
U.S. Tax Consequences
• The distribution is treated as coming from the (c)(1) category
(dollar basis of $100)
• The U.S. Shareholder recognizes $30 of foreign exchange gain
($130 less $100)
• If the U.S. Shareholder were to make a dollar pooling basis
election, it would only recognize $20 of foreign exchange gain
($130 less $110 [(€100/€200) x $220])
/ / 45
THANK YOU