The earnings and profits (E&P) of a corporation dictate the income tax treatment of non-liquidating distributions it makes to its shareholders. Distributions from a corporation to the extent of its current or accumulated E&P are taxable as dividends, which generally results in ordinary income treatment. Other distributions are treated as return of capital, which can result in no taxation or capital gains to the recipient shareholder.
Controlled foreign corporations (CFCs) are non-US corporations owned and controlled by US persons, within specific statutory parameters. US shareholders of CFCs generally must include in income a pro rata share of the Subpart F income of the CFC as such income is earned, and must also include in income non-Subpart F income when it is invested in the US by the CFC.
So what happens to the E&P of a domestic parent corporation of a CFC when that domestic corporation must include income under the above rules? Does the income create E&P as earned, or only upon later distribution of those earnings from the CFC to the domestic parent corporation?
Arguments for delaying the E&P until distribution include (1) the US parent’s ability to make dividend distributions is not increased until it receives an actual distribution from the CFC, (2) a corporation does not generally have E&P on receipt of a corporate distribution until received, and (3) the E&P cannot be in two places at once (both in the parent corporation and the CFC). Despite these arguments, the Associate Chief Counsel (International), in a legal advice memorandum, concludes that E&P is increased at the time the domestic parent corporation incurs income through the Subpart F rules.
This conclusion was based on various aspects of the E&P rules (bearing in mind that E&P is not defined under the Internal Revenue Code). For example, Treasury Regulations Section 1.312-6 ties the initial computation of E&P to gross income when it provides that items “entering into the computation of corporate earnings and profits for a particular period are ... all items includible in gross income under section 61.” Further, such treatment dovetails with Code Section 312(f)(2). Distributions of a CFC are nontaxable to its domestic shareholder to the extent of income previously taxed under these Subpart F rules, and the tax basis of the domestic shareholder is similarly decreased (to offset the increase in basis that occurred when the income was taxable to the domestic shareholder). Code Section 312(f)(2) provides that a nontaxable distribution in which the tax basis of stock is decreased, does not increase the E&P of the distributee corporation. These general E&P rules work in the context of CFC ownership only if E&P increases as income is earned by the CFC.
Legal Advice Issued by Associate Chief Counsel 2015-001