Is a Distribution of Previously Taxed Income “Exempt from Tax”?
A U.S. shareholder of a controlled foreign corporation (CFC) is required to include in its gross income its pro rata share of the CFC’s subpart F income and/or the amount determined under Section 956 with respect to such shareholder, regardless of whether any actual distributions are made to such shareholder. Because this income was taxed when earned, it is not included in the shareholder’s income when the earnings are subsequently distributed. These amounts are characterized as previously-taxed income or PTI.
The subpart F rules also provide a set of offsetting adjustments to the shareholder’s basis in the CFC stock. When an amount is included in the gross income of the shareholder under the CFC rules, the shareholder’s basis in the stock is increased by “the amount required to be included in [its] gross income.” This adjustment prevents the shareholder from incurring a second tax on the same amount if it were to sell its interest in the CFC before the distribution of the PTI. Once an actual distribution of PTI occurs, however, there is no need for a basis adjustment to protect the shareholders from tax in the event of a sale. Accordingly, the basis increase is reversed, in order to prevent a shareholder from taking a phantom loss. Accordingly, when a shareholder of a CFC receives a distribution of PTI, it reduces its basis of the stock by the amount of that distribution.
On February 4, 2015, the United States Court of Federal Claims denied motions for partial summary judgment. The Court noted that although the questions most suitable for resolution of summary judgment in the case involved statutory interpretation, it also indicated that “lurking beneath” these provisions are genuine issues of fact associated with their application. The primary issue was whether distributions of PTI by a CFC to Principal Life Insurance Company (“Principal Life”) through an LLC taxed as a partnership should be characterized as income that is “exempt from tax” under Section 705(a)(1)(B) and therefore increase Principal Life’s basis in its partnership interest. (Principal Life made this argument even though it was not the taxpayer that picked up the subpart F inclusion in its gross income). Is this were the correct statutory interpretation, Principal Life would be able to dramatically reduce the amount of gain that it would be liable for on the sale of its partnership interests.
Transactions at Issue
The issue arose from two transactions entered into between Principal Life and Deutsche Bank: the Whispering Woods LLC (“Woods”) transaction that was initiated in 1999 and the Whistling Pines LLC (“Pines”) transaction that was initiated in 2001. These transactions were “standardized structured products” marketed to Principal Life by Deutsche Bank. In both transactions, Principal Life received distributions of PTI through its membership in an LLC.
In each transaction, Principal Life and a Deutsche Bank subsidiary formed an LLC, intended to be treated as a partnership. Principal Life contributed cash, while Deutsche Bank contributed 100% of the stock of several CFCs, which were created specifically for these transactions and contained PTI transferred to them by another Deutsche Bank affiliate.
In each transaction, the LLC invested cash in a domestic corporation (“USCO”) in exchange for stock of USCO. Deutsche Bank and the CFCs also contributed cash to USCO in exchange for stock, with the result that Deutsche Bank was the controlling shareholder of USCO.
During the two-year term of the LLC, the CFCs issued two after-tax, fixed-rate payments to the LLC from their reserves of PTI. The LLC then distributed 99% of the PTI to Principal life and 1% to the Deutsche Bank subsidiary. In the Woods transaction, the LLC received payments of $24.1 million and $23.8 million in PTI distributions. In the Pines transaction, the LLC received $13.96 million and $15.8 million in PTI distributions.
At the end of each LLC’s two-year term, Deutsche Bank bought out Principal Life’s membership interest in the LLC and the LLC was wound up. Woods was sold for $499,949,895.69 and Pines was sold for $369,865,848.58.
On its tax returns, Principal Life excluded the distributions of PTI from its gross income pursuant to Section 959(a) based on its belief that the PTI had already been taxed and was distributed through Principal Life’s membership in Woods and Pines. Principal Life also adjusted its outside basis in Woods and Pines to reflect the distribution of PTI that each LLC received from the CFCs.
Principal Life argued that the Code requires (i) an increase of the basis by Principal Life’s distributive share of the PTI distribution to the LLCs under Section 705(a)(1)(B) and (ii) a decrease of the basis by the full amount of the distribution to Principal Life under Section 961(b)(1). As a result of these offsetting adjustments, Principal Life reported only $571,019 in capital gains on the sale of its membership interests in Woods and only $175,221 on the sale of its membership interests in Pines.
The IRS, on the other hand, argued that only a single basis adjustment was required under Section 961(b)(1) and that such an adjustment would result in a basis decrease by Principal Life in the amount of the PTI distributions. This would cause Principal Life to recognize substantially larger gains on the sale of its membership interests than it reported.
Is PTI Income “Exempt from Tax”?
The resolution of this issue turns on whether a distribution of PTI is considered “income exempt from tax” under Section 705(a)(1)(B). Generally, partners in a partnership are required to increase their basis in their partnership interests by, among other items, “income of the partnership exempt from tax under this title.” Principal Life argued that the PTI distributions received by Woods and Pines represented income that was exempt from tax, and therefore, allowed it to increase its outside basis in these two partnerships.
There is little authority on what constitutes tax-exempt income tax for this purpose. It is generally believed that only income that is permanently exempt from tax should result in a basis increase under Section 705(a)(1)(B). For example, interest on tax-exempt government bonds that is excluded under Section 103 and life insurance proceeds that are excluded under Section 101(a) should be covered by this provision, whereas income that is realized but not recognized in connection with a like-kind exchange (Section 1031), condemnation (Section 1033), or reorganization (Section 354) should not trigger a basis increase under Section 705. The rationale being that the latter provisions are intended not to forgive the tax on income realized, but merely to defer it until some future time. The question is which category of income should PTI fall under – income that is permanently exempt from tax or income that is realized but not recognized until some future time.
Principal Life argued that PTI should be treated as income that is permanently exempt from tax. Specifically, Principal Life argued that a distribution of PTI is a distribution of property made by a CFC to its shareholders out of the CFC’s current or accumulated earnings and profits and that, in the absence of an exception, such a distribution would be treated as a dividend includible in gross income under Section 61(a)(7) and Section 316(a). Section 959(a) makes it clear that these earnings and profits “shall not…be again included in the gross income” of a U.S. shareholder.
This argument is analogous the U.S. Supreme Court’s holding in Gitlitz v. Commissioner, 531 U.S. 206 (2001), in which the U.S. Supreme Court was asked to consider whether cancellation of indebtedness income should be characterized as “tax-exempt” income for purposes of determining whether a shareholder of an S corporation is entitled to a basis increase under Section 1367. In that case the Supreme Court held that
[t]he statute’s plain language establishes that excluded discharged debt is an ‘item of income,’ which passes through to shareholders and increases their bases in an S corporation’s stock. Section 61(a)(12) states that discharge of indebtedness is included in gross income. And § 108(a) provides only that the discharge ceases to be included in gross income when the S corporation is insolvent, not that it ceases to be an item of income, as the Commissioner contends.
(It should be noted that the interpretation of the basis adjustment rules adopted by the Supreme Court in Gitlitz was subsequently overturned by legislative action. See Section 108(d)(7)).
The IRS, on the other hand, argued that PTI distributions are not tax-exempt income of the partnership but merely the receipt of distributions that were previously included in gross income and taxed under Section 951. This is consistent with how the IRS views PTI distributions in the context of calculating the earnings and profits of a U.S. corporate shareholder of a CFC. In a recent General Legal Advice Memorandum (AM 2015-001), the IRS stated that “[u]nlike exempt income, PTI distributions constitute income that has already been subject to tax, rather than income that is never taxed.”
Principal Life, however, countered that if PTI distributions are not income at all, then Section 959(a) would be superfluous, which undercuts the IRS’s interpretation of not only Section 959(a) but also Section 705(a)(1)(B) as it relates to Section 959(a). This approach, Principal Life asserted, would create unintended consequences to the partners, including application of reporting requirements and basis adjustments that would apply differently to each partner.
As noted above, it is not clear whether a distribution of PTI constitutes tax-exempt income under Section 705(a)(1)(B) that gives rise to a basis increase. There are compelling arguments that can be made on both sides. What is clear is the potential planning opportunity that arises should Principal Life be successful in this case. Rather than directly owning shares of a CFC that has PTI, it clearly would be more advantageous to own such shares indirectly through a partnership. This would provide for a net basis adjustment of zero to the U.S. shareholder’s basis in its partnership interest rather than solely a negative basis adjustment that is required under Section 961(b) when a distribution of PTI is made. As illustrated above, this outcome would result in a substantial reduction in the gain recognized on a future sale of such partnership interest by an indirect U.S. shareholder of the CFC.