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IRS provides guidance on section 965 transition tax

On December 22, 2017, President Trump signed “an Act to provide for reconciliation pursuit to Titles II and V of the concurrent resolution on the budget for fiscal year 2018” (a.k.a. the “Tax Cuts and Jobs Act”)(“the Act”) into law. The Act is the most significant overhaul of America's tax system in decades and includes fundamental changes to international taxation in the U.S. The vast majority of the statutory changes impact 2018 filing years, and beyond. The most significant component of the Act that impacts 2017 income tax filings is the deemed repatriation of deferred foreign income. The deemed repatriation of deferred foreign income statute is a one-time tax on certain income earned outside the U.S. The one-time income inclusion related to offshore earnings denotes a point of demarcation from the historic taxing regime to the new taxing regime.

Deemed repatriation of deferred foreign income

Under pre-Act law, U.S. persons were generally not taxed in the U.S. on foreign subsidiary income until it was repatriated in the form of a dividend. Under section 965 of the Act, U.S. shareholders are required to pay a “transition tax” on the untaxed foreign earnings of specified foreign corporations as if those earnings had been repatriated to the U.S. The term “transition tax” is a reference to the aforementioned transition from the old regime to the new regime. Some of the most salient considerations of the new statute include:

  • Deferred income held in cash would be effectively taxed at 15.5 percent and any remaining amounts at 8 percent. (Section 965(c)). “Cash” is a defined term and includes other liquid assets.
  • An election is available to pay the tax liability over an eight-year period. (Section 965(h)).
  • Special rules exist for S-corporations that would allow for continued deferral. The available deferral would generally end when a “triggering event” occurs. “Triggering event” is one of many newly defined terms. A triggering event for section 965 deferral generally occurs when the structure or ownership of the S-corporation is altered in some way.
  • The income inclusion amount can be reduced by earnings and profits (E&P) deficits. There is now even greater pressure to be able to document the global E&P position of U.S. taxpayers.
  • A reduced foreign tax credit applies to the inclusion. (Section 965(g)). This generally relates to C-corporation taxpayers.

The statute, as drafted, left many significant outstanding questions that needed to be addressed in calendar year 2017 income tax filings. Additionally, the impact of section 965 appears to be wildly inconsistent between the types of U.S. taxpayers (individuals, C-corporations, S-corporation shareholders, etc.). It is unlikely that technical corrections will be available soon and it is equally unlikely that full-blown regulations are in the foreseeable future. Therefore, the Internal Revenue Service (“IRS”) has been working to provide additional guidance in the form of notices. Notices 2018-07 and 2018-13 were issued by the IRS in January. These notices provided some of the much-needed guidance related to the following section 965 application issues:

  • Details were provided on how to calculate the potential income inclusion amount, including the measurement of E&P as well as the process to allocate deficit E&P pools against positive E&P pools.
  • Details were provided related to the participation exemption amount. The participation exemption will reduce the inclusion amount such that the effective tax rate on the gross inclusion amount will align with the aforementioned 15.5 percent and 8 percent effective tax rates.
  • Details were provided on how to measure cash. Cash includes cash, net accounts receivables, the fair market value of actively traded personal property, commercial paper, certificates of deposit, governmental securities, short-term obligations and foreign currency. The cash date of measurement is either the last day of the 2017 year or the average balance of the prior two yearends (whichever amount is higher).
  • Specified Foreign Corporations (SFC) is another newly defined term. SFCs are the entities whose earnings are potentially pulled into the one-time income inclusion amount. SFCs include controlled foreign corporations as well as any foreign corporation with respect to which one or more domestic corporations is a U.S. shareholder (10 percent corporations).

On March 13, 2018, the IRS issued a series of frequently asked questions (FAQs) that outlined how taxpayers subject to the Section 965 transition tax should report and pay the tax liability on their 2017 income tax returns. The FAQs also include information on various elections taxpayers can make under section 965. The FAQs include, in part:

  • Which U.S. taxpayers are required to report amounts under section 965 on a 2017 income tax return?
  • How, and in what format, amounts are reported on 2017 income tax returns?
  • What elections are available, who can make those elections, how the elections are made and what are the election due dates with respect to section 965 on 2017 income tax returns?
  • How should a taxpayer pay the tax resulting from section 965 for 2017 income tax returns?
  • What is the expanded Form 5471 filing requirements and disclosure statement guidance?

Also, the FAQs provide several disclosure and election templates for taxpayer reference.

The IRS has promised to continue issuing section 965 guidance throughout the 2017 tax filing season. Additional guidance related to the post-2017 application issues of the Act is also forthcoming.

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