Pitfalls under new sec. 959 ordering rules.

In the Revenue Reconciliation Act of 1993, Congress expanded the antideferral regime of subpart F by amending the ordering rules of Sec. 959, Exclusion from Gross Income of Previously Taxed Earnings and Profits. The new ordering rules can have a significant effect on year-end planning for controlled foreign corporations (CFCs), as CFC shareholders can unwittingly trigger double income recognition in the year of a distribution.

New Sec. 959(f)(2) requires current-year distributions, and their effects on earnings and profits (E&P), previously taxed income (PTI) and any other item, to be taken into account before the determination of income includible under Sec. 951(A)(1)(B) and (C) - otherwise known, respectively, as Sec. 956 (Investment of Earnings in U.S. Property) and Sec. 956A (Earnings Invested in Excess Passive Assets) inclusions. The subpart F inclusions provided for under Sec. 951(a)(1)(A) continue to be taken into account before distributions. The amendment applies to CFC tax years beginning after Sept. 30, 1993, and to the tax years of their U.S. shareholders in which or with which such CFCs' tax years end. Prior to the amendment, a CFC would determine the character of distributions after all current-year income inclusions (if any) had been determined under Sec. 951(a).

Generally stated, the amendment prevents a CFC from classifying a current-year Sec. 956 or 956A inclusion as PTI for purposes of current-year distributions. The new rules may thus accelerate the recognition of income when a CFC has current Sec. 956 and 956A inclusions and makes an actual distribution to its U.S. shareholders. The following example illustrates the effects of the new ordering rules.

Example: CFC, in year 1, generates $200 in non-subpart F operating income ("good income") and makes an investment in U.S. property of $100. In the same year, CFC distributes $100 to its U.S. parent, P. Under old law, P recognized $100 of income from CFC in year 1, while under new law P recognizes $200. Old law: Sec. 956 is applied before the character of the distribution is determined. Thus, P has a $100 Sec. 956 inclusion, which is then considered to be PTI for the current year. Under the ordering rules of Sec. 959(c), the $100 distribution is allocated to PTI first and then to other E&P. Therefore, the $100 distribution has been made tax free to P, because it is allocated to the PTI generated on the current-year Sec. 956 inclusion. New law: Sec. 956 is applied after the character of the distribution is determined. CFC's only E&P consists of $200 of good income. Since these earnings are not treated as PTI in the current year (i.e., they were not included in P's income under Sec. 951(A)(1)[A)), the distribution allocated to them will be fully taxable. As a result, P recognizes $100 of dividend income. P additionally recognizes $100 in a Sec. 956 inclusion under Sec. 951(a)(1)(B).

Sec. 959(f)(2) accelerates the timing of income recognition. P recognizes only $100 in year 1 under the old law, because the current year Sec. 956 inclusion is classified as PTI before the distribution is made. CFC's E&P after the distribution consists of $100 of non-PTI, which will not be taxable to P until distributed in a future year or included under Sec. 951(a)(1)(B) or (C). However, P can no longer distribute current-year Sec. 956 and 956A inclusions tax free under the new law; such amounts are not considered PTI until year 2. Thus, CFC's E&P after the distribution under new law consists of $100 in PTI that cannot be distributed tax free until the following year (or later).

CFC shareholders planning year-end distributions should remain cognizant of Sec. 959(f)(2). To the extent that a CFC does not have sufficient PTI before considering current year Sec. 956 and 956A inclusions, any distributions could be taxable in the year distributed in addition to the current Sec. 956 and 956A inclusions.