Section 965 Basis Election Presents Unique Tax Planning Opportunity

| 5/2/2019
Final regulations published on Feb. 5, 2019, adopt proposed regulations under IRC Section 965 and allow U.S. shareholders to make a one-time election to adjust the basis of stock held in certain foreign corporations. This basis election can help mitigate potential future adverse tax consequences under IRC Section 965 that could result from remittances of previously taxed income (PTI) or transactions involving stock of the foreign corporation such as a sale or other disposition.

Generally, taxpayers have until May 6, 2019, to make a basis election with respect to returns due (including extensions) on or before that date. Taxpayers that made a basis election under the proposed IRC Section 965 regulations can revoke that election on or before May 6, 2019, by attaching a revocation statement to an amended return. No late election relief is available for either the election or revocation of a previously made election. The basis election for returns due after May 6, 2019, are due with a timely filed return (including extensions) for the year in which the inclusion under IRC Section 965 is reported.

Background

In general, the basis of a U.S. shareholder’s stock in a specified foreign corporation (SFC) is increased by amounts required to be included in gross income under the IRC Section 965 transition tax. An SFC is a controlled foreign corporation (CFC), but only for domestic shareholders that hold at least 10% of the CFC under the ownership rules of Section 958(a) and for any other foreign corporation that has a corporate 958(a) shareholder. Previously taxed earnings and profits (PTEP) of a profitable SFC (also known as a deferred foreign income corporation or DFIC) is increased by the amount of income included under Section 965(a) as well as any losses allocated to the DFIC under Section 965(b) from an SFC with a cumulative deficit (Deficit SFC). Generally, distributions of an SFC’s PTEP are excluded from taxable income by the U.S. shareholder unless the distribution of PTEP exceeds basis.

Traditionally, stock basis in a CFC is increased by an amount equal to PTEP in order to prevent double taxation in the event of a taxable sale of the investment before PTEP is distributed. A distribution of PTEP reduces basis in the stock. These general principles are applicable to SFCs for PTEP created as a result of the transition tax except that, by statute, basis is increased only by the amount of PTEP related to IRC Section 965(a) and not the PTEP created as a result of deficits allocated under IRC Section 965(b). Increasing basis in an SFC by an amount less than the increase in PTEP creates a potential for distributions of PTEP to exceed basis and cause a taxable event.

Fortunately, the final regulations under Section 965 provide for an elective basis increase at each SFC that matches the Section 965(b) PTEP, provided the basis in the Deficit SFCs are reduced by a like amount.1 Although the provision in the final regulations eliminates the mismatch of PTI and basis at DFICs, it creates a potential for taxable gain related to the Deficit SFCs when stock basis in a Deficit SFC is reduced to below zero. To prevent the recognition of gain at Deficit SFCs, the final regulations allow taxpayers to limit the amount of the downward basis adjustment at the Deficit SFC provided that the basis increase spread among profitable SFCs is similarly reduced.2

The basis election is available with respect to all DFICs and Deficit SFCs, and a conformity requirement stipulates if the election is made by a U.S. shareholder, all parties related to the U.S. shareholder must make the basis election. Furthermore, basis adjustments are permitted only for SFC stock that is owned directly by U.S. shareholders.3 It is not entirely clear how the rules affect basis adjustments of lower-tier foreign corporations.

Practical considerations and next steps

Because of the complexities associated with basis adjustment calculations and the time constraints for making the election, taxpayers should start considering the following immediately to determine whether to make a basis election:
  • The specific legal entity structure – that is, which SFCs are owned directly by the U.S. shareholder(s) and, therefore, are eligible for basis adjustments
  • The current tax stock basis and fact patterns that could benefit from the basis election – for example, identification of low-basis DFICs and significant amounts of Section 965(b) PTI
  • The specific repatriation plans and the manner in which PTI would be remitted in the future
  • The ability to limit upward and downward basis adjustments to avoid gain recognition as well as the interplay of the gain reduction rule if distributions already were made during the inclusion year
  • The other tax planning actions that could serve to “move” PTI within the structure – for instance, check-the-box elections

 

1Treasury Regulation 1.965-2(f)(2).
2Treasury Regulation 1.965-2(f)(2)(ii)(A)(2) and 1.965-2(f)(2)(ii)(B)(2).
3Treasury Regulation 1.965-2(h)(5)(i).

 

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