Sec. 956 and subpart F inclusions, actual distributions, and previously taxed income.

• Author: Yu, Hui

Under Sec. 959(a), a distribution by a controlled foreign corporation (CFC) out of earnings and profits (E&P) that have been included in the income of a U.S. shareholder, commonly referred to as previously taxed income (PTI), is not included in the U.S. shareholder's income a second time. The PTI rules were designed to prevent double taxation of a CFC's earnings. Keeping track of a foreign corporation's E&P under the Sec. 959 ordering rules can be complicated, with different categories of PTI as well as non-PTI.

A CFC's E&P can be divided into three categories, commonly known as: * Sec. 959(c)(1) account, from prior-year Sec. 956 inclusions; * Sec. 959(c)(2) account, from current- or prior-year subpart F income inclusions and Sec. 1248 deemed-dividend inclusions; and * Sec. 959(c)(3) account (other E&P, i.e., non-PTI).

Under the ordering rules, an actual distribution is treated as made first out of the Sec. 959(c)(1) account, then out of the Sec. 959(c)(2) account, and finally out of the Sec. 959(c)(3) account. Within each Sec. 959(c) account, PTI is considered distributed on a last-in, first-out (LIFO) basis.

Example: USP, a U.S. corporation, owns 100% of CFC1, a foreign holding company that is a CFC. CFC1 owns CFC2, another CFC and an operating company. CFC2 has owned 100% of DC, a U.S. corporation, since Jan. 1, year 1, with an adjusted basis of $3 in its DC stock. CFC2 has E&P of $10 in year 1. During year 2, CFC1 earns subpart F income of $5; CFC1 makes a distribution of $50 to USP on June 1; CFC2 makes a distribution of $6 to CFC1 on Dec. 1; CFC2 makes an entity classification election to be disregarded as an entity separate from its owner, CFC1, on Dec. 15; and CFC2 sells 100% of DC stock to a third party for cash at fair market value on Dec. 30, realizing a gain of $4.

Year 1 CFC2's ownership of shares in DC constitutes an investment in U.S. property under Sec. 956, giving USP a Sec. 956 inclusion to the extent of the lesser of (1) CFC2's E&P or (2) the adjusted basis of CFC2 in DC stock, which is $3 in year 1. This Sec. 956 inclusion in year 1 becomes CFC2's PTI in year 2--Sec. 959(c)(1) PTI.

Year 2 Generally, under Sec. 959(f)(2), actual distributions during the year are taken into account before current-year Sec. 956 inclusions. Therefore, $3 of the Dec. 1, year 2, distribution of $6 from CFC2 to CFC1 should be treated as made out of PTI from the year 1 Sec. 956 inclusion, and the remaining $3 of that distribution should be...