COVID-19 is an unprecedented event that altered the course of history, society, and economies on a global scale.
The outbreak is disrupting businesses and consumer behavior on a massive scale. In the U.S., as public and private companies take action to minimize the spread of the virus, they face significant cash flow and liquidity challenges. One possible avenue for U.S. companies facing a cash flow crisis is to consider repatriating cash from their foreign operations.
Now is the time for companies to determine if they have excess cash sitting in their foreign subsidiaries and how to repatriate that excess cash by taking into consideration Notice 2019-1 and Treas. Reg. 1.960-3 (c) that provides guidance regarding Previously Tax Earnings and Profit (“PTEP”).
A U.S. shareholder of a controlled foreign corporation (“CFC”) can be subject to tax on the earnings of the CFC even if the U.S. shareholder does not receive a cash remittance from the CFC. There are several different categories of income that a CFC can earn that would give rise to such an income inclusion for the U.S. shareholder. These include but are not limited to the CFC’s investment in U.S. property, Subpart F income, GILTI, and Section 965 transition tax inclusions. There are some scenarios where a CFC’s income has not been subjected to tax in the hands of the U.S. shareholder.
For purposes of this article, we will categorize E&P into three different baskets[1]. The 1st basket is PTEP related to Section 956 investments in U.S. property and amounts reclassed from the 2nd basket. The 2nd basket is PTEP from Subpart F income, GILTI, and Sec. 965 inclusions. The 3rd basket is E&P that has not yet been subject to tax.
The Notice and the Regulations provide guidance as to how a remittance from the CFC will deplete each category of PTEP. As a general rule, remittances from a CFC will follow a last-in, first-out (“LIFO”) methodology beginning with the 1st basket so that if a CFC had investments in U.S. property that gave rise to income inclusions in the hands of the U.S. shareholder, current year remittances will first reduce the most recent year’s PTEP in that basket and then previous years’ PTEP in that basket until the PTEP in the 1st basket is entirely depleted. Then, the most recent year’s PTEP in basket two is utilized, and so on until all PTEP has been utilized. If the remittance exceeds all PTEP, the U.S. shareholder will then be subject to tax on the additional amount of the remittance that corresponds to non-previously taxed E&P.[2]
However, this general rule has an exception, and that is that priority is given to PTEP related to the mandatory deemed repatriation of Section 965 despite that as discussed above, 965 inclusions are in the 2nd basket. For example, if a U.S. shareholder included an amount in its income under Section 965 in 2017, remittances from the CFC will first deplete the PTEP from that category. This is the case even in a situation where the U.S. shareholder made an election under Section 965(h) to pay the tax due over eight annual installments. Once Section 965 PTEP is depleted, the next basket to be depleted is everything in basket one and then basket two, to the extent thereof.
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The Notice provides an example. Assume a foreign corporation has PTEP and E&P for the prior three years as follows:
| 959(c)(1) “1st basket” |
959(c)(2) “2nd basket” |
959(c)(3) “3rd basket” |
|
| 2018 | $60 | $160 | $40 |
| 2017 | $250 | $50 | |
| 2016 | $50 | $50 |
Assume that in 2018, the foreign corporation makes a distribution of $420 to the U.S. shareholder. Further, assume that $200 of the amount in 2017 in the 1st basket relates to Section 965 PTEP, and the entire $50 in the 2nd basket 2017 relates to Section 965 PTEP.
Under the LIFO rules, one would assume that the distribution would first come out of the $60 from the 2018 1st basket. However, that is not the case. Rather, the Notice and Regulations provide that the distribution will first be sourced out of Section 965 PTEP in the 1st basket, i.e., $200. After that $200 is depleted, the LIFO rules kick in to utilize all of the remaining $160 of PTEP in the 1st basket. Once that basket is fully depleted, the distribution is then sourced first to the Section 965 PTEP of $50 in the 2nd basket and finally LIFO on the remainder of the 2nd basket.
To conclude, a U.S. shareholder having liquidity and/or cash flow issues may consider repatriating the cash sitting in their foreign operations. The U.S. shareholders should consider whether their foreign CFC has any PTEP that could be repatriated. If it is determined, it does have it, detailed analysis, and additional attention will be given to determine how they can repatriate while addressing the foreign currency gain or loss that will trigger the distribution of PTEP.
Authors: Josh Gelernter | [email protected], Rajesh Tripathi | [email protected] and Kimberlee Phelan | [email protected]
International Services Tax
Footnotes:
[1] The Notice and Regulations describe up to 16 different baskets; for simplification purposes, we will group the more relevant ones into three.
[2] If the remittance exceeds all E&P, the principals of Section 301(c) will apply so that the additional remittance is treated first as a return of basis and then as a capital gain once basis has been entirely returned.
