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On December 28, 2023, the U.S. Treasury Department (“Treasury”) and the U.S. Internal Revenue Service (“IRS”) released Notice 2024-16 (the “Notice”), announcing their plan to issue proposed regulations addressing the treatment of notional basis adjustments under section 961(c)[1] when all of the stock of a lower-tier “controlled foreign corporation” within the meaning of section 957(a) (“CFC”) is transferred by a CFC to a U.S. acquiring corporation in a section 332 liquidation or certain asset reorganizations described in section 368(a)(1). The stated purpose of the proposed guidance is to prevent double taxation of a CFC’s previously taxed earnings and profits (“PTEP”) in the hands of the U.S. acquiring corporation, which is consistent with the purpose of section 961 itself.[2] However, because the scope of the Notice is narrow, the Notice does not alleviate all instances of double taxation of PTEP that may result from the inbound transfer of stock of a lower-tier CFC. Taxpayers may rely on the rules described in the Notice for transactions completed on or before the date that the proposed regulations are published in the Federal Register, provided that they and all related parties consistently apply all the rules in the Notice.
The Subpart F and GILTI regimes require a “United States shareholder” within the meaning of section 951(b) (“U.S. Shareholder”) of a CFC to currently include in its gross income the U.S. Shareholder’s pro rata share of the “subpart F income” of such CFC and the U.S. Shareholder’s “global intangible low-taxed income” with respect to such CFC. The rules under sections 959 and 961 operate together to allow the U.S. Shareholder to avoid a second level of tax when the PTEP attributable to such prior income inclusions are either repatriated through a distribution from such CFC to the U.S. Shareholder (or to an upper-tier CFC) or the U.S. Shareholder (or an upper-tier CFC) recognizes additional amount realized attributable to such PTEP as a result of the sale of the stock in such CFC.
Under section 961(a), a U.S. Shareholder must increase its tax basis in the stock of a first-tier CFC by the amount of income included in such U.S. Shareholder’s gross income under the subpart F and GILTI regimes with respect to such stock, including amounts attributable to lower-tier CFCs indirectly owned (within the meaning of section 958(a)) by such U.S. Shareholder by reason of owning stock in the first-tier CFC. Because section 961(a) is only intended to prevent double taxation with respect to the undistributed PTEP of a CFC, under section 961(b)(1), a U.S. Shareholder is required to reduce the basis of stock of a first-tier CFC by the amount of a PTEP distribution received from such CFC that is excluded from gross income under section 959(a). Generally, section 959(a) provides that the earnings attributable to amounts that have been included in the gross income of a U.S. Shareholder under section 951(a) shall not, when actually distributed, be again included in the gross income of such U.S. Shareholder (or its successor-in-interest). Under section 961(b)(2), to the extent that an amount excluded from the U.S. Shareholder’s gross income under section 959(a) exceeds the U.S. Shareholder’s basis in the first-tier CFC’s stock, such amount is treated as gain from the sale or exchange of property (i.e., the stock of the first-tier CFC).
While sections 961(a) and (b) have been in the Code since the subpart F regime was first enacted in 1962, Congress added section 961(c) to the Code in 1997 as part of a legislative package that was meant to address certain statutory gaps when an upper-tier CFC sold the stock of a lower-tier CFC.[3] Section 961(c) provides that, under regulations,[4] if a U.S. Shareholder is treated under section 958(a)(2) as owning stock in a lower-tier CFC, adjustments similar to those provided by section 961(a) and (b) must be made with respect to the basis of the stock in such lower-tier CFC, but only for purposes of determining the amount included in the gross income of such U.S. Shareholder under section 951. In general, section 961(c) is intended to ensure that a U.S. Shareholder is not taxed a second time on undistributed PTEP with respect to a lower-tier CFC when an upper-tier CFC sells the stock of such lower-tier CFC.[5]
Following the acquisition of lower-tier CFC stock in an inbound nonrecognition transaction, a U.S. corporation generally inherits the upper-tier CFC’s adjusted basis in the stock of the lower-tier CFC pursuant to section 334(b) or 362(b), as applicable. However, section 961(c) notional basis adjustments only apply for purposes of determining the amount to be included in a U.S. Shareholder’s gross income under section 951 (i.e., the section 961(c) notional basis is not “real basis” for all Code purposes) and a U.S. acquiring corporation cannot have a subpart F inclusion as a result of a sale of first-tier CFC stock. Therefore, a U.S. acquiring corporation’s adjusted basis in the stock of the acquired CFC does not reflect the section 961(c) notional basis adjustments that the upper-tier transferor CFC had in such stock prior to the inbound nonrecognition transaction.
Accordingly, absent regulatory guidance, a U.S. corporation may recognize gain on a subsequent distribution of PTEP from an acquired CFC under section 961(b)(2) or upon the disposition of the acquired CFC stock that is attributable, in each case, to amounts previously included in the income of the U.S. Shareholder under the subpart F and GILTI regimes. The Notice stated that Treasury and the IRS were concerned that such double taxation of PTEP would discourage taxpayers from engaging in certain inbound nonrecognition transactions.
To avoid double taxation, the Notice announces that forthcoming proposed regulations will provide that, in the case of a “covered inbound transaction” (as defined in the Notice and further discussed below), a U.S. corporation’s adjusted basis in the acquired CFC stock, as provided under section 334(b) or 362(b), will be determined by taking into account the transferor CFC’s notional basis adjustments with respect to such acquired CFC stock under section 961(c). However, as further discussed below, the Notice applies only to a narrow class of inbound nonrecognition transactions. Furthermore, it applies only to the extent the notional basis adjustments under section 961(c) derive from the U.S. corporation’s previous subpart F or GILTI inclusions or where the U.S. corporation inherits the section 961(c) notional basis as a successor. This leaves U.S. Shareholders in other common transactions with the same double taxation concerns that the Notice and section 961 itself are intended to address.
The forthcoming proposed regulations are expected to define a “covered inbound transaction,” with respect to an acquired CFC, as one of the following transactions in which (a) a U.S. acquiring corporation acquires all of the stock of the acquired CFC from a transferor CFC and (b) immediately before such acquisition and any “related transactions,”[6] such transferor CFC owns (directly or indirectly under section 958(a)(2)) all of the stock of the acquired CFC. The transactions that may qualify as “covered inbound transactions” are:
(i) Section 332 Liquidations and Upstream Asset Reorganizations - A section 332 liquidation, a nontriangular A reorganization (i.e., a reorganization described in section 368(a)(1)(A) (but not section 368(a)(2)(D) or 368(a)(2)(E))) and a nontriangular C reorganization (i.e., a reorganization described in section 368(a)(1)(C) (determined without regard to the parenthetical in section 368(a)(1)(C))), in each case, in which all of the stock of the transferor CFC is owned directly by the U.S. acquiring corporation immediately before the transaction; and
(ii) Other Asset Reorganizations - A nontriangular A reorganization, a nontriangular C reorganization, a reorganization described in section 368(a)(1)(D) (that satisfies the requirements of section 354(b)(1)(A) and (B)) and a reorganization described in section 368(a)(1)(F), in each case, in which all of the stock of the transferor CFC is owned directly by a single U.S. corporation (or by members of the same consolidated group) immediately before the transaction, and that same U.S. corporation (or members of the same consolidated group) directly owns all of the stock of the U.S. acquiring corporation immediately after the transaction and any related transactions.
Note that, in general, an inbound nonrecognition transaction can only be a “covered inbound transaction” if, immediately before the transaction, the transferor CFC owned all of the stock of the acquired CFC and a single U.S. corporation or consolidated group (as the case may be) owned all of the stock of the transferor CFC.
Two de minimis rules provide very narrow relief from these strict ownership requirements. Under the de minimis rules, a transaction may still constitute a “covered inbound transaction” if: (a) immediately before the transaction, one or more persons, other than a single U.S. corporation or members of a consolidated group (as the case may be), own (in the aggregate) one percent or less of the total fair market value of the stock of the transferor CFC; or (b) immediately before the transaction and any related transactions, one or more persons other than the transferor CFC own (in the aggregate) one percent or less of the total fair market value of the stock of the acquired CFC, provided that any such person(s) must continue to own its stock in the acquired CFC after the transaction and any related transactions if the person(s) is not related (within the meaning of section 267(b) or 707(b)(1)) to the U.S. acquiring corporation.
In addition to the narrow definition of “covered inbound transaction” discussed above, the Notice contains certain specific limitations on the scope of the relief.
Under the specific limitations, a transaction will not be a “covered inbound transaction,” and therefore will not give effect to a section 961(c) notional basis adjustment in the acquired CFC stock for purposes of determining the U.S. acquiring corporation’s tax basis in the acquired CFC stock under section 334(b) or section 362(b) in the case of any of the following:
Even without the explicit limitations described above, the universe of transactions covered by the Notice is limited. As discussed above, the Notice only applies to inbound section 332 liquidations and certain inbound asset reorganizations and, even then, only when a U.S. corporation acquires all of the stock of the acquired CFC from a transferor CFC that, immediately before the transaction and any related transactions, owns (directly or indirectly) all of the stock of the acquired CFC. There are myriad common structures and transactions that the Notice does not apply to, despite the fact that such structures and transactions give rise to the precise double taxation issue that the Notice and section 961 itself are intended to address.
For example, the Notice would not apply if 100% of the stock of a lower-tier CFC were transferred inbound upon the section 332 liquidation of a brother-sister, first-tier CFC holding structure. Consider, for instance, a structure in which a U.S. corporation (“USP”)[9] directly owns 100% of the stock of each of two first-tier, brother-sister CFCs (“CFC 1” and “CFC 2”). In turn, CFC 1 directly owns 50% of the stock in a second-tier CFC (“CFC 3”), and CFC 2 directly owns the remaining 50% of the stock in CFC 3. Assume that CFC 1 and CFC 2 each has $50 of cost basis in its CFC 3 stock and, as a result of a $100 subpart F inclusion attributable to CFC 3, each has $50 of section 961(c) notional basis in its CFC 3 stock.
Under the Notice, when CFC 1 and CFC 2 liquidate into USP in a section 332 liquidation (which may be done to simplify USP’s corporate structure by eliminating superfluous legal entities), such that USP becomes the direct owner of 100% of the stock in CFC 3, USP would not inherit any of the section 961(c) notional basis adjustments that CFC 1 and CFC 2 had in the stock of CFC 3 because neither CFC 1 nor CFC 2 (the transferor CFCs) directly or indirectly own (under section 958(a)(2)) all of the stock of CFC 3 (the acquired CFC). As result, if USP later sells the stock of the acquired CFC (CFC 3) for $200, because its carryover basis in such CFC would not reflect the $100 of section 961(c) notional basis adjustment resulting from the prior subpart F inclusion with respect to the CFC 3 stock, USP would recognize gain of $100 on such stock sale. Similarly, if CFC 3 distributes $200 to USP (including the $100 of PTEP and return of capital of $100), USP would recognize $100 of gain under section 301(c)(3). This gain results from the $100 PTEP distribution reducing its $100 carryover basis to $0 under section 961(b)(1). In either case, USP would be subject to double taxation on CFC 3’s $100 of PTEP.[10]
A stock reorganization (or a section 351 exchange) is another transaction that may implicate the same double taxation concern but for which the Notice does not afford beneficial treatment. For instance, consider a transaction in which USP wholly owns an upper-tier CFC (“CFC 4”) that transfers all of the stock in a lower-tier CFC (“CFC 5”) to an unrelated U.S. corporation (“USCo”) solely in exchange for voting stock in USCo in a transaction that constitutes a tax-free reorganization described in section 368(a)(1)(B) (i.e., a B reorganization).[11] Assume that CFC 4 has $100 of cost basis in its CFC 5 stock and, as a result of a $200 subpart F inclusion attributable to CFC 5, has $200 of section 961(c) notional basis in its CFC 5 stock.
Although this transaction should constitute an inbound reorganization of lower-tier CFC stock, because B reorganizations are not “covered inbound transactions” under the Notice, USCo’s tax basis in the stock of CFC 5, as determined under section 362(b), would not reflect any of the historical section 961(c) notional adjustments to the basis of CFC 5 stock that were made in the hands of CFC 4. As a result, if USCo receives a distribution of more than $100 from CFC 5, as USP’s successor in interest (assuming that USCo satisfies the requirements of section 1.959-1(d) of the Treasury regulations), it should be able to exclude up to $200 of such distribution from gross income under section 959(a). However, because USCo’s carryover basis in CFC 5 would not reflect the $200 of section 961(c) notional basis adjustment resulting from USP’s prior subpart F inclusion with respect to the CFC 5 stock, any amount in excess of $100 would give rise to gain in the hands of USCo—first, under section 961(b)(2) and, second, under section 301(c)(3). Similarly, if USCo subsequently sold the CFC 5 stock for its fair market value of $300, it would recognize $200 of gain. This gain equals the PTEP balance and prior section 961(c) notional basis adjustments that were not accounted for in USCo’s basis calculation.[12]
Accordingly, although the guidance in the Notice may eliminate double taxation in certain transactions in which lower-tier CFC stock is inbounded, given its limited scope, it fails to address many common fact patterns that may arise in cross-border transactions and internal restructurings.
A taxpayer may rely on the guidance provided in the Notice for transactions completed on or before the date the forthcoming proposed regulations are published in the Federal Register, provided the taxpayer and its related parties (within the meaning of sections 267(b) and 707(b)(1)) follow the rules in their entirety and in a consistent manner.
For purposes of, and prior to, applying the guidance provided in the Notice, taxpayers that have maintained section 961(c) notional basis in a non-U.S. dollar currency must convert such basis into U.S. dollars under a reasonable method consistently applied to all acquired CFCs in any covered inbound transaction undertaken by one or more U.S. acquiring corporations. For this purpose, a reasonable method must use an exchange rate that reflects the original U.S. dollar inclusion amounts of the U.S. Shareholder that gave rise to the section 961(c) notional basis, reduced as appropriate, including for PTEP distributions on such stock.
[1] All section references herein are to the Internal Revenue Code of 1986, as amended (the “Code”), or the Treasury regulations promulgated thereunder.
As the Notice acknowledges, the section 961(c) basis is not treated as “real basis” for all purposes of the Code and, accordingly, we refer to it here as “notional basis.”
[2] H.R. Rep. No. 1447, at A106 (1962) (stating that the basis of stock of a CFC will be adjusted “[t]o prevent doubling up of tax where stock in a controlled foreign corporation is sold at a gain which reflects the retained earnings already taxed to United States persons….”).
[3] Taxpayer Relief Act of 1997, Pub. L. No. 105-34, § 1112(b), 111 Stat. at 969 (as amended by the Gulf Opportunity Zone Act of 2005, Pub. L. No. 109-135, § 409(b), 119 Stat. at 2635–36); see also J. Comm. on Tax’n, General Explanation of Tax Legislation Enacted in 1997 (JCS-23-97) (Dec. 17, 1997).
[4] To date, no final or temporary regulations have been issued under section 961(c).
[5] See H.R. Rep. No. 105-148, at 450 (1997) (explaining that, pursuant to section 961(c), “just as the basis of a U.S. 10-percent shareholder in a first-tier CFC rises when subpart F income is earned and falls when previously taxed income is distributed, so as to avoid double taxation of the income on a later disposition of the stock of that company, the subpart F income from gain on the disposition of a lower-tier CFC generally is reduced by income inclusions of earnings that were not subsequently distributed by the lower-tier CFC”); S. Rep. No. 105-33, at 160–61 (1997) (same); H.R. Conf. Rep. No. 105-220, at 510–11 (1997) (same).
[6] The Notice does not define the term “related transactions.”
[7] Interestingly, the specific limitation related to a built-in loss in acquired CFC stock turns off the relief provided under the Notice completely, rather than applying the principles of section 362(e)(1) to eliminate the built-in loss in the acquired CFC stock.
[8] Unlike the preceding limitation, which provides a carve out for transfers to other members of a consolidated group, this limitation does not contemplate any exceptions for controlled partnerships. As a result, even a transfer by a U.S. acquiring corporation to a partnership that is wholly owned by members of the same consolidated group as the U.S. acquiring corporation would cause the transaction to fail to qualify for the relief provided in the Notice.
[9] The same result would arise where the stock of CFC 2 was wholly owned by a member of USP’s consolidated group.
[10] It is possible that this unexpected result could be avoided if CFC 1 merged into CFC 2 and then USP waited a sufficient amount of time before liquidating CFC 2. However, USP should carefully consider the step-transaction doctrine in such a case.
[11] The same result would arise where the stock of CFC 5 represents substantially all of the assets of CFC 4 and CFC 4 liquidates in connection with the transaction, resulting in the transaction constituting a tax-free reorganization described in section 368(a)(1)(C).
[12] It is worth noting that this result would not arise if USP and USCo had completed a reorganization of the first-tier CFC stock in CFC 4, with respect to which USP has “real” section 961(a) basis that should carryover to USCo. However, there may be non-tax business reasons for USCo to directly acquire the stock in CFC 5 rather than CFC 4.
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