Section 959(c)(2) PTEP Distribution Ordering Rules

The United States taxes domestic corporations on their worldwide income but has historically allowed for the deferral of tax on the active earnings of foreign subsidiaries. Anti-deferral regimes, such as the Subpart F and Global Intangible Low-Taxed Income (GILTI) provisions, limit this deferral by requiring U.S. shareholders of Controlled Foreign Corporations (CFCs) to include a portion of the CFC’s income in their own taxable income, regardless of whether they receive a cash distribution.

This current taxation can lead to double taxation: once when the income is earned by the CFC and again when that same income is distributed as a dividend. To prevent this, the Internal Revenue Code uses Section 959 to track these amounts as Previously Taxed Earnings and Profits (PTEP). This framework allows the future distribution of these earnings to be tax-free and governs the tax consequences of repatriating cash from foreign operations.

The Concept of Previously Taxed Earnings and Profits

Previously Taxed Earnings and Profits (PTEP) represent a foreign corporation’s earnings that have already been subject to U.S. income tax at the shareholder level before any actual distribution occurred. Once an amount is classified as PTEP, it can be distributed to the U.S. shareholder without being taxed again as a dividend.

The creation of PTEP stems from several inclusion provisions in the Internal Revenue Code. The most common sources include:

• Inclusions under Subpart F, which target a CFC’s passive income and certain related-party sales and services income.
• The GILTI regime, which taxes U.S. shareholders on a broad measure of a CFC’s net income exceeding a routine return on its tangible assets.
• Section 956 inclusions, which treat a CFC’s investment in U.S. property, such as a loan to its U.S. parent, as a deemed distribution to the shareholder.

Distribution Ordering Rules

Section 959 establishes a strict, multi-layered system for determining the tax character of distributions from a CFC to its U.S. shareholders. This framework dictates the order in which a CFC’s earnings and profits (E&P) are considered distributed. The regulations categorize E&P into distinct pools, and distributions are sourced from these pools in a specific sequence.

The first category of earnings distributed is PTEP described in Section 959(c)(1). This pool consists of E&P previously included in a shareholder’s income due to an investment in U.S. property under Section 956. Distributions are considered to come from this basket first, allowing for a tax-free return of these deemed inclusions.

Following distributions of 959(c)(1) PTEP, the next layer sourced is PTEP under Section 959(c)(2). This broad category contains the E&P previously taxed to U.S. shareholders under the Subpart F and GILTI regimes. Distributions from this category are also excluded from the U.S. shareholder’s gross income. An exception gives priority to PTEP generated by the one-time transition tax under Section 965, meaning these amounts are sourced from both the 959(c)(1) and 959(c)(2) pools before any other PTEP.

Only after all PTEP in the 959(c)(1) and 959(c)(2) categories has been distributed are subsequent distributions sourced from Section 959(c)(3) E&P. This pool contains all other E&P of the foreign corporation that have not been previously taxed. Distributions from this layer are treated as taxable dividends, subject to foreign tax credits. For example, if a CFC with $10 in 959(c)(1) PTEP, $30 in 959(c)(2) PTEP, and $50 in 959(c)(3) E&P makes a $50 distribution, the first $40 is tax-free PTEP and the final $10 is a taxable dividend.

Required Accounting and Tracking

Compliance with the Section 959 rules requires detailed record-keeping. The foundation of this process is the annual calculation of the CFC’s E&P under U.S. tax principles, which often requires adjusting the foreign corporation’s local financial statements. This E&P calculation identifies which earnings are subject to current U.S. tax and which become part of the non-taxed 959(c)(3) pool.

Beyond the overall E&P study, taxpayers must maintain specific PTEP accounts for each U.S. shareholder. These accounts are not just at the corporate level; they must track ownership on a shareholder-by-shareholder basis because the right to receive a tax-free distribution belongs to the shareholder who had the original income inclusion. The tracking must reflect the opening balance of PTEP, additions from current-year inclusions, and reductions from distributions.

The Tax Cuts and Jobs Act of 2017 introduced “PTEP groups,” which increased tracking complexity. PTEP must be segregated into multiple groups based on the nature of the underlying income and the year it was earned. For instance, PTEP from GILTI must be tracked separately from PTEP arising from Subpart F income.

This granular tracking is necessary for the correct application of foreign tax credit rules and dictates how distributions are sourced. Distributions are sourced from annual PTEP accounts on a last-in, first-out (LIFO) basis. However, when a distribution is sourced from a single year’s account, it is drawn on a pro-rata basis from the different PTEP groups created in that year.

Reporting on Form 5471

The accounting and tracking of PTEP culminate in reporting on Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” U.S. shareholders must translate their E&P and PTEP tracking records into the specific formats required by this return.

Schedule J, “Accumulated E&P of Controlled Foreign Corporation,” provides a summary of the CFC’s total E&P at the corporate level. On this schedule, the taxpayer reports the opening and closing balances of the CFC’s E&P, broken down into the Section 959 categories. The schedule shows the portion of E&P classified as 959(c)(1) PTEP, 959(c)(2) PTEP, and non-previously taxed 959(c)(3) E&P.

Schedule P, “Previously Taxed Earnings and Profits of U.S. Shareholder,” shifts the focus to the shareholder’s specific interest in that PTEP. This schedule requires the taxpayer to report their pro-rata share of PTEP, organized by the various PTEP groups. For each group, the shareholder must report an opening balance, detail any current-year inclusions, and subtract any distributions received, providing the IRS with a clear reconciliation of amounts that can be repatriated tax-free.