2023 End of Year Tax Update | December 2023

Favorable IRS guidance concerning mid-year PTEP distributions and Section 961 basis adjustments

In 2023, the IRS provided advice regarding the interaction of 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. 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 that are 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 helpful to understand the IRS viewpoint. In short, the IRS’s approach is favorable to taxpayers who have a mid-year PTEP distribution from a CFC and require an upward CFC stock basis adjustment for current year inclusions to avoid gain recognition on the PTEP distribution itself.

Section 961 provides for CFC stock basis adjustment rules with respect to U.S. shareholders. In general:

1. CFC stock basis increases occur when a U.S. shareholder has CFC income inclusions (for instance, Subpart F and Global Intangible Low-Taxed Income (GILTI)),
2. CFC stock basis reductions occur when PTEP related to such inclusions is distributed by a CFC, and
3. Gain recognition results if a CFC PTEP distribution exceeds the adjusted basis of CFC stock.

However, Section 961 does not indicate the timing of basis adjustments, but treasury regulations provide that a basis increase is to occur as of the last day in the taxable year of such corporation on which it is a CFC, a basis decrease occurs at the time the U.S. shareholder receives the PTEP distribution, and the timing of any gain recognition is not addressed.

In PLR 202304008, the IRS dealt with a scenario involving a U.S. corporation that owned a CFC and received a mid-year distribution of PTEP. The U.S. corporation had inclusions under Subpart F and GILTI, which gave rise to PTEP 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 during the tax year.

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 taken into account when determining whether any gain is recognized. The IRS provided that not taking the basis increase into account when determining the amount of any gain recognition would produce discordance between Sections 959 and 961. Section 959(c) allows for a non-taxable distribution of PTEP to be available for distributions made at any time during the year, while under Section 961, the basis related to such PTEP would protect against gain recognition only if the PTEP is distributed on or after the last day of the taxable year. Requiring gain recognition if PTEP is distributed on any earlier day would be contrary to Section 959 and Section 961's common purpose of preventing double taxation.

The Supreme Court accepts constitutional challenge to Section 965 transition tax

On June 26, 2023, the Supreme Court of the United States agreed to hear a rare constitutional challenge concerning the validity of the transition tax under Section 965. The Supreme Court Justices will consider whether the transition tax is a tax on income within the meaning of the Sixteenth Amendment or a direct non-income tax that must be apportioned among the states.

In general, as part of the TCJA of 2017, the transition tax caused accumulated post-1986 earnings and profits (E&P) of certain foreign corporations to be taxed as Subpart F at the level of 10% for U.S. shareholders. In Moore v. United States, Charles and Kathleen Moore made an investment in an Indian business for 11% of the stock. As a result of the transition tax, the Moore’s had an income inclusion with respect to their pro rata share of the Indian corporation’s accumulated E&P resulting in $15,000 of income tax. In the challenge, the Moore’s have argued that by taxing them on gains to their investment that they never received, or “realized,” themselves as income, the government had imposed a direct tax, which the Constitution says must be apportioned among the states. Prior to acceptance by the Supreme Court, the U.S. Court of Appeals for the Ninth Circuit upheld the tax holding that there is no constitutional requirement that income taxed by the federal government be realized by the taxpayers.

The Moore’s have argued that the Sixteenth Amendment exemption from state apportionment is limited to taxes on realized gains, partially based on Eisner v. Macomber and Glenshaw Glass. Further, the text of the Sixteenth Amendment contemplates that “income” will be “derived” from a source. Alternatively, the government has argued that whether a taxpayer has realized income does not determine constitutionality and what constitutes a taxable gain is broadly construed. The government’s brief even asserts that a finding for the Moore’s positions “would call into question the constitutionality of many other tax provisions that have long been on the books.”

It is unclear how the Supreme Court may rule in this case because there is a range of possibilities but a broad ruling rather than a narrow ruling in favor of the Moore’s could have massive implications throughout the tax law by calling into question the constitutionality of many other areas of taxation. For instance, it would call into question Subpart F and GILTI, which would result in a significant revenue loss to the government and create additional consequence to taxpayers, such as the tax treatment of prior distributions thought to be from PTEP. Carried to its furthest, albeit unlikeliest, conclusion, a broad opinion in favor of the petitioners could invalidate wide sections of the IRC not related to foreign income recognition, including treatment of domestic pass-through entity income.

Taxpayers may wish to consider the implications, including filing protective claims for refund for the transition tax or other taxes.

IRS issues temporary relief from controversial foreign tax credit regulations

On July 21, 2023, IRS Notice 2023-55 provided temporary relief to taxpayers in determining the creditability of certain foreign taxes by deferring components of Treas. Reg. Sections 1.901-2 and 1.903-1, issued December 28, 2021 (FTC Final Regulations). For tax years beginning on or after December 28, 2021 (i.e., the first tax years for application), and ending on or before December 31, 2023, taxpayers may choose to apply prior regulations (Prior FTC Regulations) which are more favorable to determine what qualifies as a creditable foreign tax. The Notice indicates that the Treasury Department and IRS are considering proposing amendments to the FTC Final Regulations. Additionally, the Treasury Department and IRS are considering whether, and under what circumstances, to provide additional temporary relief described in the Notice to tax years beyond the relief period.

In general, a taxpayer can claim a credit against its federal income tax liability for foreign income taxes (subject to limitation). The FTC Final Regulations substantially revised what qualifies as a creditable foreign tax by revising a “net gain test” and its realization, gross receipts, and net income tests, and added a new attribution requirement. A stringent cost recovery requirement in the revised net gain test required foreign tax law to allow recovery for all “significant costs and expenses” attributable to gross receipts in the foreign tax base. Taxpayers were later generally provided with some relief related thereto.

With respect to resident taxpayers, under the attribution test, arm’s length principles must be utilized under a country’s transfer pricing rules which created creditability concerns for taxes in certain foreign jurisdictions (e.g., Brazil). For nonresident taxpayers, the attribution test could be satisfied when one of three tests is met:

1. An activities-based attribution test,
2. A source-based attribution test, or
3. A property-based attribution test.

The introduction of the attribution test was originally intended to limit the creditability of “novel extraterritorial taxes” (such as digital services taxes) which the Treasury believed would undermine the objective of the foreign tax credit regime. Due to the attribution test, the creditability of foreign withholding taxes on royalties sourced based on the location of the payor may not have been creditable as well as foreign withholding taxes on cross-border services payments not sourced based on place of performance.

The Notice allows taxpayers to apply certain aspects of the Prior FTC Regulations which results in a taxpayer only needing to satisfy the prior net gain test instead of the more restrictive one in the FTC Final Regulations. It also allows taxpayers to suspend application of the attribution test such that a foreign jurisdiction’s sourcing rules does not need to align with the U.S. Consequently, many foreign withholding taxes should be creditable that might not have been under the FTC Final Regulations as well as nonresident capital gains taxes. Digital service taxes remain uncreditable. Finally, a taxpayer must adhere to a consistency requirement and apply the Prior FTC Regulations to all foreign taxes of the taxpayer, including a CFC held by the taxpayer. It remains to be seen if this is a temporary reprieve or effectively a withdrawal.

An executive summary overview of OECD Pillar 2

The Organization for Economic Co-operation and Development (OECD)/G20 Global Anti-Base Erosion (Pillar 2) Model Rules intend to address perceived challenges to traditional international taxation principles due to the increases in a digitized economy. With implementation it would significantly impact the taxation of multinational corporate groups, introducing more complexity and eliminating the benefit of lower-tax jurisdictions.

Pillar 2 rules would apply to multinational groups with global revenues exceeding a €750mthreshold. A group is defined as a collection of enterprises that are consolidated for financial accounting purposes. Pillar 2 would apply to subsidiaries included in consolidation, including permanent establishments, branches, and entities disregarded for U.S. federal income tax purposes (DREs).

Pillar 2 has two proposals:

1. A Global Anti-Base Erosion (GloBE rules) regime, which includes an Income Inclusion Rule (IIR) and an Undertaxed Payments Rule (UTPR) (in addition to a Switchover Rule (SOR) where required), and
2. A minimum level of tax on certain payments between connected parties, which are viewed to base erode (Subject to Tax Rule (STTR)).

In short, the IIR requires an ultimate parent entity to pay a top-up tax on its proportionate share of the income (direct or indirect) of any low-taxed enterprise in consolidation. The top-up tax is meant to bring the effective rate of tax to 15%. Any top-up tax is net of any Qualified Domestic Minimum Top-Up Tax (QDMTT), which is a minimum tax in domestic law and shaped consistent with GloBE rules. As a result, source countries retain primary taxing rights over profits sourced in their jurisdiction. An ultimate parent entity is given priority to apply the IIR but if its jurisdiction has not implemented the IIR, the IIR falls on an enterprise in consolidation that is directly owned and controlled by the ultimate parent entity and further down the ownership chain.

The UTPR is a backstop to the IIR and is meant to address instances where the IIR does not bring low tax jurisdictions to a minimum 15% ETR. It allocates taxing rights to jurisdictions different than the ultimate parent entity location.

The STTR is taken into consideration to compute the ETR and effectively operates as a priority rule. It is relevant when intragroup payments are subject to an adjusted nominal tax rate below the 15% minimum ETR. If so, the source state may levy a withholding tax equal to the top-up tax on the gross payment.

U.S. GILTI rules presumably are not considered a qualifying IIR unless Congress modifies the GILTI regime so that is applies a 15% minimum ETR on a country-by-country basis which might be an uncertain prospect. If not changed, U.S.-parented groups may be subject to the application of UTPRs to top-up tax amounts of their CFCs. In February 2023, the OECD released temporary administrative guidance that was welcome news to U.S. multinational groups impacted by Pillar 2. It provided that the GILTI regime is a blended CFC tax regime and GILTI taxes may generally be creditable against GloBE top-up taxes, subject to a prescribed allocation methodology. In effect, GILTI tax is first allocated to comparatively low-tax jurisdictions with higher income in meeting the minimum 15% test.

For large U.S. multinational groups within the scope of the rules, they should now consider the impact of Pillar 2 on its global tax liability and the additional reporting and compliance burden.