Section 961 Adjustments to Basis of CFC Stock

U.S. persons who own stock in foreign corporations are subject to a complex set of tax rules. Section 961 of the Internal Revenue Code is an accounting tool within this system that prevents the same corporate earnings from being taxed twice. It achieves this by adjusting a shareholder’s cost basis in the corporation’s stock. When a U.S. shareholder pays tax on a foreign corporation’s undistributed profits, Section 961 treats it as if the shareholder received those profits and then reinvested them back into the company. This conceptual reinvestment increases the stock basis, ensuring the taxed amounts are not taxed again upon a future distribution or sale.

The Upward Basis Adjustment

The upward basis adjustment under Section 961(a) is a direct consequence of rules that require U.S. shareholders to pay tax on certain foreign earnings before they are physically received. This occurs primarily through Subpart F income inclusions and Global Intangible Low-Taxed Income (GILTI) inclusions. When a shareholder includes these amounts in their gross income, the law mandates a corresponding increase in their basis of the Controlled Foreign Corporation (CFC) stock as of the last day of the CFC’s taxable year. The logic behind this increase is to create tax parity between a domestic investment and a foreign one.

This adjustment simulates a reinvestment of the taxed earnings, reflecting the shareholder’s greater economic interest in the corporation. For example, a U.S. individual owns 100% of a CFC with an initial basis for the stock of $50,000. In the current year, the shareholder has a GILTI inclusion of $10,000, though no cash is distributed, and they must report this on their U.S. income tax return.

Under Section 961(a), the shareholder must increase their basis in the CFC stock by the amount of the GILTI inclusion. Their adjusted basis becomes $60,000 ($50,000 basis + $10,000 inclusion). This $10,000 amount is now considered Previously Taxed Earnings and Profits (PTEP). This basis increase is a required step that prevents a future sale of the stock from resulting in a higher capital gain, which would effectively tax the same $10,000 of GILTI income again.

The Downward Basis Adjustment

A downward basis adjustment under Section 961(b) is the countervailing mechanism to the upward adjustment. This reduction in basis occurs when a CFC distributes earnings that have already been taxed in the United States, known as Previously Taxed Earnings and Profits (PTEP). When a shareholder receives a distribution of PTEP, the law excludes this amount from their gross income.

A distribution of PTEP represents a return of the shareholder’s investment. Since the stock basis was increased when the tax was originally paid, the subsequent tax-free receipt of that cash is treated as a recovery of basis. This downward adjustment maintains the system’s integrity, as it prevents a shareholder from receiving a tax-free distribution while also benefiting from an artificially high basis on a future sale.

Continuing the previous example, the U.S. shareholder has an adjusted basis of $60,000 in their CFC stock, which includes $10,000 of PTEP. In the following year, the CFC distributes $8,000 in cash. Because the CFC has a PTEP account of $10,000, the entire $8,000 distribution is sourced from these previously taxed earnings and is received tax-free.

Concurrently, the law requires the shareholder to reduce their basis in the CFC stock by the amount of the tax-free distribution. Their adjusted basis is decreased by $8,000, resulting in a new basis of $52,000 ($60,000 – $8,000). This adjustment ensures the basis accurately reflects the capital remaining in the corporation.

Tax Implications of Distributions and Dispositions

The basis adjustments under Section 961 have direct tax consequences when a shareholder sells CFC stock or receives distributions. The adjusted basis is the figure used to determine the amount of taxable gain or loss realized upon a disposition. When a U.S. shareholder sells CFC stock, the gain or loss is calculated by subtracting their adjusted basis from the sale price.

An upward basis adjustment from a Subpart F or GILTI inclusion will reduce the calculated capital gain or increase the capital loss. For instance, assume a shareholder initially purchased CFC stock for $100,000. Over several years, they had a total of $40,000 in GILTI inclusions, which increased their basis to $140,000. If they later sell the stock for $150,000, their taxable capital gain is only $10,000 ($150,000 sale price – $140,000 adjusted basis).

A special rule exists to prevent a shareholder from receiving a double tax benefit from certain dividends. If a domestic corporation receives a dividend from a foreign subsidiary and claims a deduction for it under the participation exemption system, the corporation must reduce its basis in the foreign subsidiary’s stock by the amount of that dividend. This basis reduction applies only for the purpose of calculating a loss on a future sale of the stock, which prevents the corporation from enjoying a tax-free dividend and then also claiming an artificially high capital loss.

The tax treatment of distributions from a CFC follows a detailed ordering rule. Distributions are first sourced from PTEP accounts, which are received tax-free by the shareholder and reduce the stock basis. PTEP itself is separated into different categories, and distributions are treated as coming from them in a specific order:

• First, from earnings previously taxed due to the CFC’s investment in U.S. property.
• Second, from PTEP created by Subpart F and GILTI income inclusions, generally on a last-in, first-out (LIFO) basis.

If a distribution exceeds the CFC’s total PTEP, the excess amount is then treated as a dividend to the extent of the CFC’s other, non-previously-taxed earnings and profits. Any remaining amount of the distribution is treated as a tax-free return of capital, reducing any remaining stock basis. If a distribution exceeds the stock basis, the excess is treated as a capital gain.

Special Rule for Basis in Other Property

The basis adjustment rules of Section 961 extend beyond situations where a U.S. shareholder owns CFC stock directly. A special provision addresses scenarios of indirect ownership, such as when a shareholder holds an interest in a foreign partnership or a foreign trust that, in turn, owns the CFC stock. This rule was added to the code to address concerns about potential double taxation upon the sale of lower-tier CFCs.

Under this rule, the basis adjustments that would normally be made to the CFC stock are instead applied to the U.S. shareholder’s basis in the intermediary foreign entity. For example, if a U.S. person owns an interest in a foreign partnership that owns a CFC, any Subpart F or GILTI inclusion from the CFC would increase the U.S. person’s basis in their partnership interest, not the partnership’s basis in the CFC stock itself.

The logic is to provide the U.S. shareholder with a basis increase in the asset they directly own and can sell. When the shareholder eventually sells their interest in the foreign partnership, the higher basis will result in a lower capital gain, reflecting that they have already paid U.S. tax on the CFC’s underlying earnings.

Similarly, when the intermediary entity receives a tax-free PTEP distribution from the CFC, the U.S. shareholder’s basis in their partnership or trust interest is reduced. This mirrors the downward adjustment for direct owners and prevents an improper tax benefit. This provision adapts the core principles of basis adjustments to more complex, multi-layered ownership structures.