IRS Provides Favorable Guidance on Mid-Year PTEP Distributions and the Section 961 Basis Issue

At a glance

• The main takeaway: The IRS has provided guidance regarding basis adjustment rules under Section 961 and mid-year PTEP distributions. The guidance may provide helpful perspective for taxpayers that do not have sufficient basis in controlled foreign corporation stock to avoid recognizing gain on a mid-year PTEP distribution.
• Impact on your business: The guidance, which was released in a private letter ruling and an advice memorandum, is not binding, but it is still beneficial for taxpayers to understand the IRS’s viewpoint ─ especially since the issue has become more prevalent since the passage of the Tax Cuts and Jobs Act.
• Next steps: Aprio’s International Tax team can help multinational companies facing this issue better understand the IRS’s taxpayer-favorable viewpoint, while providing additional tax guidance on their unique situation.

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The full story:

The Internal Revenue Service (IRS) has recently provided advice regarding the interaction of the basis adjustment rules under Section 961 and previously taxed earnings and profits (PTEP) distributions by a controlled foreign corporation (CFC) that occur before the last day of its tax year. Taxpayers may confront this issue when they do not have sufficient basis in CFC stock to avoid recognizing gain on a mid-year distribution of PTEP.  

In Private Letter Ruling (PLR) 202304008 and Advice Memorandum (AM) 2023-002, the IRS concluded that Section 961(a) basis increases due to foreign income inclusions must be taken into account to determine if gain must be recognized on a mid-year CFC PTEP distribution. 

The PLR and AM are not binding guidance, but nonetheless it is helpful for multinational companies to understand the IRS’s taxpayer-favorable view, which we will explain in this article.

Background on Section 959 and Section 961

When a US shareholder has had CFC income inclusions (e.g., Sections 951(a) and 951A), Section 959 provides that a distribution of those earnings is not subject to US federal income tax (i.e., avoids double taxation).

In general, Section 961 provides CFC stock basis adjustment rules for US shareholders:

1. CFC stock basis increases when a US shareholder has CFC income inclusions._[1]
2. CFC stock basis reductions when PTEP is distributed by a CFC._[2]
3. Gain recognition if a CFC PTEP distribution exceeds the adjusted basis of the CFC stock._[3]

Treas. Reg. 1.961-1(a) provides guidance on the timing of a basis increase to occur as of the last day in the taxable year of such corporation on which it is a CFC. In contrast, Treas. Reg. 1.961-2(a)(1) provides that any basis decrease occurs at the time the US shareholder receives the PTEP distribution, and the timing of any gain recognition is not addressed. Understanding how these rules interact is crucial in cases where taxpayers need the basis increase to avoid recognizing a gain on mid-year PTEP distributions.

What guidance is included in PLR 202304008?

In PLR 202304008, the IRS dealt with a scenario involving a US corporation that owned a CFC and received a mid-year distribution of PTEP. The US corporation had inclusions under Section 951(a) and 951A, which gave rise to PTEP under Section 959 and a corresponding basis increase under Section 961(a). The issue at hand was whether the taxpayer could utilize the Section 961(a) basis increase at the time of the mid-year distribution to avoid gain recognition.

In its ruling, the IRS permitted the basis increase under Section 961(a) to be utilized in determining the tax consequence of the PTEP distribution occurring earlier in the tax year.

What guidance is included in AM 2023-002?

Similarly, in AM 2023-002, the IRS analyzed a fact pattern involving a mid-year PTEP distribution and provided insight into how and why the rules should operate in a manner that permits the Section 961(a) basis increase to be considered when determining whether any gain is recognized.

The facts of the AM provided that a domestic corporation (USP) wholly owned a CFC. Prior to Year 1, USP’s adjusted basis in its CFC stock and PTEP account were both zero. In Year 1, USP had $100 of CFC foreign income inclusions and increased its PTEP account by this amount. On June 30 of Year 1, the CFC distributed $100 to USP, which was excluded from USP’s gross income and decreased its PTEP accounts. 

In the AM, the IRS concluded that for the purposes of determining gain recognition on the $100 PTEP distribution, USP’s adjusted basis in its CFC stock was $100. Thus, USP does not recognize gain because of the PTEP distribution. The IRS acknowledged that Section 961 does not specifically address a mid-year distribution scenario and the timing rules could be read to conclude that for purposes of determining gain recognition, the adjusted basis of USP’s CFC stock is computed before or after taking into account the $100 increase. Considering that final PTEP can only be determined at the end of the taxable year, the IRS felt that the better interpretation was to take into account an increase in CFC stock basis when determining gain recognition on the mid-year distribution. 

Further, because Sections 959 and 961 are companions designed to prevent double taxation, requiring gain recognition if the PTEP is distributed earlier would defeat the purpose. Otherwise, in this type of scenario, PTEP could only be distributed on or after the last day of the CFC’s taxable year.

The bottom line

The IRS’s approach in the PLR and AM is favorable to taxpayers who have mid-year PTEP distributions from a CFC and require an upward CFC stock basis adjustment for current-year inclusions to avoid gain recognition on the PTEP distribution itself.  

While the guidance is not binding, and taxpayers cannot rely on PLRs, it does provide a clearer understanding of the IRS’s position on the issue, as it should be considered by the IRS within taxpayer audits. 

If you have any questions regarding the IRS’s guidance or your specific tax situation, contact Aprio’s International Tax team today.

Related Resources

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[1] Section961(a).

[2] Section 961(b)(a).

[3] Section 961(b)(2).