AM 2015-01—Does Previously Taxed Income 'Tier Up' To A Domestic Corporate Shareholder?

Introduction

In a recent chief counsel memorandum (AM 2015-01), the IRS addressed a long uncertain tax question: when a US corporate shareholder includes an amount in income under subpart F, does the subpart F inclusion increase the corporate shareholder's "earnings and profits" immediately or only when the earnings are actually distributed as a tax-free distribution of previously taxed income ("PTI")? Despite the IRS's answer, the AM primarily reveals the ambiguity inherent in the question. As can be gleaned from the AM, "earnings and profits" and PTI questions remain uncertain at best and difficult to predict without reference to the specific facts and provision at issue and exercise of careful judgment.

The IRS Conclusion in the Advice Memorandum

Subpart F taxes US shareholders on inclusions of subpart F income and amounts determined under Section 956. To prevent double taxation, Section 959 allows the shareholder to exclude from its gross income an amount of CFC's earnings and profits equal to the previously taxed amounts when actually distributed to the shareholder. Further, in a system of notional investment adjustments, Section 961 increases the shareholder's basis in CFC stock for the amounts included by the shareholder in income under subpart F, and decreases the shareholder's basis in CFC stock by the amount of previously taxed earnings distributed.

In AM 2015-01, the IRS addressed the implications of a subpart F inclusion in the calculation of the US Parent's earnings and profits account. (Such earnings and profits would be relevant primarily to determine whether a distribution by the US Parent to its shareholders constitutes a dividend or potential return of capital).

In theory, there are at least two possible times at which a subpart F inclusion might affect the US Parent's earnings and profits. First, subpart F income could increase E&P of the US Parent when it is earned by the CFC and included in taxable income by the Parent — i.e., by treating the subpart F income as if it were an actual dividend of the CFC's earnings. Second, subpart F income might increase E&P of the US Parent only when actually distributed by the CFC or treated as distributed through a sale of CFC stock, on the theory that the distribution of PTI is akin to tax-exempt income that must be added to E&P due to the increase of corporate net worth.

Each of these approaches appears to have some support in the case law definition of "earnings and profits." The former approach would seem to be supported by the "accounting consistency" rule, which provides that amounts of taxable income are taken into account at the same time for income tax and earnings and profits...