Since the Tax Cut and Jobs Acts (TCJA) was passed, taxpayers have been waiting for guidance on whether distributions from foreign income taxed in 2017 would be taxed or not. In the meantime, the name of previously taxed income (PTI) has even been changed to previously taxed earnings and profits (PTEP). 

To finally address some of these issues, the IRS issued proposed regulations under Section 959.

PTEP Taxation

Deferred income in majority U.S.-owned foreign corporations, also known as controlled foreign corporations (CFCs), was subject to tax under Section 965 in installment payments over a period of eight years as part of a transition to a participation exemption system of taxation (sometimes called a territoriality system of taxation). However, the various types of earnings and profits (E&P) that could be held by a CFC, as well as an annual layering of the E&P types, led to questions about how the distributions were to be treated, especially if the eight-year period had not yet run.

Further complicating the situation, individuals who owned a CFC were treated differently in the taxation of E&P earned in years after 2017 than corporations that owned a CFC. There were also concerns that an individual might not have the same resources to pay the tax over the eight-year period. Therefore, an election under Section 962 was available to individuals where they were treated like a corporation and allowed to claim a foreign tax credit (FTC) on the taxes paid by the CFC on this deferred income (something not normally allowed). 

So how were PTEP distributions taxed to the individual who made this election? In the complex world of international taxation, the U.S. Internal Revenue Code (IRC) provides a framework for how foreign earnings are taxed. Two important components of this framework include the Section 965 priority rule and the Section 962 ordering rules. These rules play a crucial role in determining how PTEP is treated, especially in the context of distributions and inclusions under the U.S. tax system. 

The following reviews these two areas of importance, especially to individuals who own CFCs.

Section 965 Priority Rule

The Section 965 priority rule is a specific guideline within the broader context of the U.S. tax code that deals with how PTEP is treated. This rule was introduced as part of the TCJA, which imposed a one-time transition tax on the untaxed foreign earnings of certain specified foreign corporations.

Key features of the Section 965 priority rules include: 

1. Simplification of PTEP tracking: It simplifies the tracking and administration of PTEP by prioritizing the distribution of earnings subject to the transition tax under Section 965. This helps in reducing the complexity associated with maintaining multiple PTEP accounts (unless, of course, an individual made an election under Section 962 at any point previously).
2. Order of distribution: Under this rule, PTEP resulting from Section 965(a) inclusions is prioritized for distribution before other types of PTEP. This means when a distribution is made:
   1. it is first sourced from the Section 965(a) PTEP group (which is excluded from income),
   2. followed by the Section 965(b) PTEP group (which is also excluded from income)
   3. and then finally from other PTEP groups.
3. Administrative efficiency: By prioritizing Section 965, the rule aims to eventually eliminate these specific PTEP groups, thereby reducing the overall number of PTEP groups required to be tracked. This is intended to ease the administrative burden on taxpayers and the IRS.
4. Impact on foreign tax credits: The rule also affects the availability of foreign tax credits, as distributions from Section 965 PTEP may reduce the amount of foreign taxes that can be credited against the U.S. tax liability of a U.S. corporate taxpayer.

Section 962 Ordering Rules

Section 962 of the IRC provides an election for individual U.S. shareholders of CFCs to be taxed at corporate rates on their Subpart F income and global intangible low-taxed income (GILTI) inclusions. The Section 962 ordering rules dictate how distributions of PTEP are treated when this election is in place. If a Section 962 election has been made, disregard the easing of administration comments mentioned noted as it relates to the Section 965 priority rule.

Key features of the Section 962 ordering rules include:

1. Taxation at corporate rates: When this election is made, the individual shareholder is taxed at corporate rates on income inclusions, and the amounts are treated as if they were received by a domestic corporation for purposes of applying the foreign tax credit. The highest rate of corporate tax is 21%, while individual tax rates can reach 37%.
2. Additional level of taxation: The rule ensures PTEP distributed to an individual who made this election is subject to an additional level of taxation. This is because the distributed PTEP is included in the individual's gross income to the extent it exceeds the amount of tax paid on the prior income inclusion in the year of the election.
3. Basis adjustments: The rule also provides for adjustments to the basis of the stock or other property with respect to which the PTEP is received. This prevents double benefits that could arise from the basis provided under Section 961 for the inclusion that gave rise to the PTEP.
4. Coordination with other provisions: The rule works in conjunction with other provisions of the tax code to ensure that the tax treatment of PTEP is consistent and equitable, preventing both double taxation and double non-taxation.

Here to Guide You

The Section 965 priority rule and Section 962 ordering rules are both essential components of the U.S. international tax system. They provide a structured approach to the distribution and taxation of PTEP, ensuring tax liabilities are appropriately managed. 

Understanding these rules is crucial for taxpayers navigating the complexities of international taxation, as they have significant implications for tax planning and compliance. Proper tracking is necessary to correctly report PTEP and avoid challenges (and potential assessment of penalties) from the IRS.