United States: AM 2015-01—Does Previously Taxed Income "Tier Up" To A Domestic Corporate Shareholder?

Introduction

In a recent chief counsel memorandum (AM 2015-01), the IRS addressed a long uncertain tax question: when a US corporate shareholder includes an amount in income under subpart F, does the subpart F inclusion increase the corporate shareholder's "earnings and profits" immediately or only when the earnings are actually distributed as a tax-free distribution of previously taxed income ("PTI")? Despite the IRS's answer, the AM primarily reveals the ambiguity inherent in the question. As can be gleaned from the AM, "earnings and profits" and PTI questions remain uncertain at best and difficult to predict without reference to the specific facts and provision at issue and exercise of careful judgment.

The IRS Conclusion in the Advice Memorandum

Subpart F taxes US shareholders on inclusions of subpart F income and amounts determined under Section 956. To prevent double taxation, Section 959 allows the shareholder to exclude from its gross income an amount of CFC's earnings and profits equal to the previously taxed amounts when actually distributed to the shareholder. Further, in a system of notional investment adjustments, Section 961 increases the shareholder's basis in CFC stock for the amounts included by the shareholder in income under subpart F, and decreases the shareholder's basis in CFC stock by the amount of previously taxed earnings distributed.

In AM 2015-01, the IRS addressed the implications of a subpart F inclusion in the calculation of the US Parent's earnings and profits account. (Such earnings and profits would be relevant primarily to determine whether a distribution by the US Parent to its shareholders constitutes a dividend or potential return of capital).

In theory, there are at least two possible times at which a subpart F inclusion might affect the US Parent's earnings and profits. First, subpart F income could increase E&P of the US Parent when it is earned by the CFC and included in taxable income by the Parent — i.e., by treating the subpart F income as if it were an actual dividend of the CFC's earnings. Second, subpart F income might increase E&P of the US Parent only when actually distributed by the CFC or treated as distributed through a sale of CFC stock, on the theory that the distribution of PTI is akin to tax-exempt income that must be added to E&P due to the increase of corporate net worth.

Each of these approaches appears to have some support in the case law definition of "earnings and profits." The former approach would seem to be supported by the "accounting consistency" rule, which provides that amounts of taxable income are taken into account at the same time for income tax and earnings and profits purposes. This approach essentially would treat the shareholder's net worth as increasing to reflect the step-up in basis of the CFC's stock. The distribution of PTI that reduces basis would then be treated as effectively a return-of-capital, rather than an item of tax-exempt income as seems to be contemplated by § 959(a). The latter approach, by contrast, appears to find support in the principle that E&P is "an economic concept which the tax law has utilized to approximate a corporation's power to make distributions which are more than just a return of investment." Henry C. Beck Co. v. Commissioner, 52 TC 1, 6 (1969), aff'd, 433 F.2d 309 (5th Cir. 1970) (Per curiam). As illustrated by Beck, the time when an item is realized as an economic profit (and as a component of earnings and profits) does not always correspond to the time when it is taken into account in taxable income.

In the AM, the IRS comes down firmly on the side of the former approach, and holds that a subpart F inclusion immediately increases E&P of the US Parent when included in taxable income. In support, the IRS relies on Treas. Reg. § 1.312-6(a) and related case law. Under this regulation, items of income and expense enter E&P according to the same methods of accounting used for computing taxable income. Similarly, realized but unrecognized gains (e.g., in a corporate reorganization) are generally recognized for E&P purposes at the same time as they are recognized for income tax purposes. See Treas. Reg. § 1.312-7(b)(2), Example 1 (property acquired in a non-recognition transaction has the same basis for E&P as for income tax purposes). Since subpart F income increases the shareholder's basis in its stock, the AM equates the inclusion of subpart F income with a recognition event that increases the US Parent's net worth and dividend paying ability.

Also, the IRS cites Section 312(f)(2)(A) to treat the actual distribution of PTI as not giving rise to E&P. That section provides that no adjustment to E&P shall be made for the amount of any distribution that is not taxed to the shareholder (under the law at the time the distribution is made) to the extent the distribution is directly applied in reduction of basis of the corporation's stock. An example in the regulations (Treas. Reg. § 1.312-8(b), Example 1) illustrates that this rule applies to a distribution out of pre-1913 accumulated earnings and profits that is treated as a return of capital under § 301(c)(2). The AM then relies on this section to conclude that the actual distribution of PTI (since it is excluded from income and triggers a reduction in basis) must be excluded from E&P, so that the only appropriate time to increase US Parent's E&P is at the time of the underlying subpart F inclusion.

Appraising the AM's Analysis

The AM decides the issue before it on the basis of the accounting consistency rule and § 312(f)(2). However, the AM analysis, if correct, could lead to some unusual results.

First, as noted above, E&P has commonly been said to be an "economic concept" measuring the corporation's power to make distributions that are more than a return of capital. See, e.g. Henry Beck Co., 52 T.C. at 6. Under this approach, the receipt of a dividend from a domestic subsidiary increases earnings and profits, despite the dividends received deduction, because the distribution increases the recipient's power to make distributions to its shareholders. See Weyerhauser v. Commissioner, 33 B.T.A. 594, 597 (1935); PLR 200952031 (Sept. 23, 2009). How such a dividend should be treated when there has also been a reduction in the shareholder's basis under § 1059 has been a matter of previous dispute. See Field Service Advisories #0868 (Oct. 16, 1992) and #0721 (undated) (addressing same case of a dividend-stripping transaction).

PTI is analogous to a dividend covered by a dividends-received deduction in that it is a distribution of earnings that goes untaxed in order to avoid double taxation. Like other forms of tax-exempt income, the actual distribution of PTI increases the corporate shareholder's net worth on a stand-alone basis and its ability to pay dividends to its shareholders. Prior to that time, it is debatable that there has been any accession to wealth in the economic sense. Indeed, to the extent the inclusion of subpart F income requires the shareholder to make a cash outlay to pay Federal income taxes, the shareholder's net worth is reduced.

Second, the AM's conclusion is difficult to square with the statutory language of Section 959, which treats PTI as a part of the CFC's earnings and profits. In this regard, Section 959 differs from other anti-deferral rules that treat taxable income inclusions as deemed distributed and then re-contributed to capital.1 Section 959(c), by contrast, treats the categories of PTI as part of the earnings and profits of the CFC. Section 959(a)(1) further provides for an exclusion from gross income of "earnings and profits of a foreign corporation... when such amounts are distributed" to the US shareholder, clearly implying that the PTI is an amount of earnings and profits. Under the AM, the same earnings are simultaneously included in both the CFC's and US Parent's E&P accounts.

AM 2015-01 acknowledges this concern with duplication of E&P, but relies on the consolidated return regulations for the proposition that E&P can "tier up" and be included in more than one corporation's E&P at the same time.

However, this analysis overlooks that the tiering up of E&P in a consolidated group is provided for by regulations, see Treas. Reg. § 1.1502-33, and is part of the consolidated return's investment adjustment system whereby both losses and income are reflected in the upper-tier members' E&P accounts as earned by the subsidiary, see Treas. Reg. § 1.1502-33(a)(3), Ex. 1(e). Since E&P has already tiered up to the parent of the group, the consolidated E&P of a member leaving a group also is eliminated. See Treas. Reg. § 1.1502-33(e)(1). In other words, E&P of the parent of a consolidated group is computed by treating the group largely as if it were a single entity. Subpart F, by contrast, respects the separate existence of the CFC. A CFC retains its PTI accounts in its E&P when it is sold or disposed of so that such earnings can be distributed to the purchaser. See Treas. Reg. § 1.959-1(d). Treating the E&P as if it automatically tiered up to the US Parent of the CFC upon a subpart F inclusion would seem to duplicate the same E&P in two corporations at the same time without specific statutory or regulatory authority to do so.

Conclusion

The AM reflects a strong tendency by the IRS in favor of the accounting consistency rule. Under this rule, adjustments to tax basis (upward or downward) would seem to be the appropriate time for adjusting earnings and profits, rather than a later time when the related item has a direct economic effect on the recipient corporation's net worth or dividend-paying ability.

Footnote

1. See § 565(c) (consent dividends by a personal holding company deemed distributed and then re-contributed to capital) and Former IRC § 551(f) (same for undistributed foreign personal holding company income). Subpart F deliberately avoids this approach in order to ensure that PTI remains earnings and profits of the CFC to be recovered at the earliest possible time by the US shareholder.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Events from this Firm
30 Nov 2017, Conference, San Francisco, United States

The 2017 agenda addresses significant pending legislative and regulatory changes along with our annual substantive updates.

5 Dec 2017, Webinar, California, United States

This highly interactive colloquium will provide a deep understanding and practical advice regarding major e-discovery challenges facing organizations today.

6 Dec 2017, Seminar, California, United States

Network and be seen as an information security thought leader. “The Exchange” colloquium is designed for senior business executives and security practitioners from both the public and private sector.

 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.