PLR 202304008: Taxpayer Does Not Have Section 961(b)(2) Gain for Mid-Year Distributions
Introduction to Section 961 and Mid-Year Distributions
For years, there has been a longstanding question under the subpart F rules on whether a controlled foreign corporation’s (“CFC”) mid-year earnings could be taken into account in determining section 961 basis adjustments with respect to a mid-year distribution of current year earnings to a U.S. shareholder. If a CFC distributed earnings in excess of its U.S. shareholder’s section 961(a) basis in the CFC, the distribution would trigger gain under section 961(b)(2). As a result, U.S. parented groups with CFCs were limited in the amount of current year earnings that could be distributed to avoid triggering non-economic section 961(b)(2) gain as a result of basis adjustments. In PLR 202304008, the IRS confirmed that, at least in the case of the taxpayer that submitted the PLR, mid-year earnings could be taken into account when determining a section 961(b) basis reduction. The ruling is consistent with how many international tax practitioners viewed these rules. Below, we discuss the basics of section 961 as well as the facts and ruling of PLR 202304008.
Section 961 Basis Adjustments
In a U.S. parented group with CFCs, the rules under sections 951-965 (i.e., subpart F), require each U.S. shareholder of a CFC to currently include in income its pro rata share of the CFC’s subpart F income for the tax year. Thus, when a CFC generates earnings, the U.S. shareholder of that CFC must include its pro rata share of such amounts in income. A related and important component of these rules is that under section 961(a), a U.S. shareholder is required to increase its basis in the stock of the CFC by the amount that the U.S. shareholder is required to include in income under section 951(a) with respect to such CFC stock. Similarly, under section 961(b), if a U.S. shareholder receives an amount which is excluded from gross income under section 959(a) (i.e., previously taxed earnings and profits (“PTEP”)), the U.S. shareholder is required to reduce its adjusted basis in the stock of the CFC. Typically, this involves a distribution of PTEP.
Moreover, under section 961(b)(2), if an amount that is excluded under section 959(a) exceeds the adjusted basis of the stock with respect to which it is received, the amount is treated as gain from the sale or exchange of property. In other words, if the U.S. shareholder receives a distribution that is in excess of its section 961(a) basis in the CFC, the U.S. shareholder must recognize gain as if it had sold the stock of the CFC. A common issue interpreting these rules is that they do not specify the timing of when current year earnings should be taken into account for purposes of section 961 basis adjustments. Thus, even if a CFC had current year earnings that were in excess of its basis, if the CFC made a mid-year distribution to its shareholder, it could trigger non-economic section 961(b)(2) gain since those current year earnings had not yet been taken into account. Generally, practitioners believed that current year earnings were only taken into account when the subpart F inclusion accrued at the end of the tax year. In PLR 202304008, the IRS confirmed that current year earnings are taken into account for purposes of determining section 961 basis adjustments for mid-year distributions.
PLR 202304008 – Current Year Earnings are Taken Into Account For Section 961 Basis Adjustments Resulting from Mid-Year Distributions
On January 27, 2023, the IRS released PLR 202304008. The facts of the PLR were that U.S. parent owns U.S. shareholder, which in turn, owns CFC1. U.S. parent causes CFC1 to distribute cash to U.S. shareholder before the last day of the tax year (Year 2). All of the entities use the calendar year as their taxable year. CFC1 only has one class of stock outstanding, all of which is owned by U.S. shareholder.
Additionally, the taxpayer represented that U.S. parent and U.S. shareholder will compute and report its Year 2 consolidated taxable income in accordance with all applicable rules, including keeping, maintaining and making adjustments to its and its affiliate PTEP accounts under Notice 2019-01. The taxpayer also represented that U.S. shareholder will include in its gross income its pro rata share of CFC1’s subpart F income for Year 2 and its GILTI inclusion amount ((within the meaning of Treas. Reg. §§ 1.951A-1(c)(1) and 1.1502-51). Moreover, the taxpayer represented that all or a portion of the distribution will be excluded from U.S. shareholder’s gross income under section 959(a). Other than the distribution, CFC1 will not have any actual or deemed distributions in Year 2 on or before the date of the distribution. Finally, the taxpayer represented that for one or more shares of CFC1 stock, the adjusted basis of the share at the time of the distribution and without regard to the section 961(a) basis increase will be less than the amount by which the adjusted basis of the share would be reduced under section 961(b)(1) as a result of the distribution.
Based on those facts and representations, the IRS ruled that for purposes of determining a section 961(b) basis reduction with respect to the mid-year distribution of current year earnings from CFC1 to its U.S. shareholder, the U.S. shareholder can first increase its basis in the CFC1 stock under section 961(a) for current year subpart F and GILTI amounts that the U.S. shareholder will include in gross income at the end of its taxable year. Accordingly, a U.S. shareholder in this position would no longer trigger non-economic section 961(b)(2) gain on the sale or exchange of stock of CFC1.
Observations – Will Section 961 Basis Adjustments For Mid-Year Distributions Apply to All Taxpayers?
PLR 202304008 is helpful guidance that appears to answer a longstanding question about the timing mismatch between mid-year distributions and when section 961 basis adjustments should occur with respect to CFC income inclusions to avoid section 961(b)(2) gain. As noted above, taxpayers in this position were often stuck limiting the amount of the mid-year distribution to the amount of the section 961(a) basis existing at the start of the tax year (unadjusted by current year subpart F and GILTI amounts) to avoid recognizing section 961(b)(2) gain. It remains to be seen whether the forthcoming PTEP regulations will adopt this ruling for all taxpayers, but it may be a signal of what is to come. The PTEP regulations are expected to be released sometime in 2023 and will likely address this issue.
Expert Tax Attorneys
If you need assistance analyzing subpart F, GILTI, PTEP or section 961 issues, Freeman Law can help you navigate these complex provisions. Contact us as soon as possible to discuss your rights and the ways we can assist in your defense. We handle all types of cases, including complex international & offshore tax compliance. Schedule a consultation or call (214) 984-3000 to discuss your international tax concerns or questions.