By Anthony Diosdi
Introduction to the Transition Tax
Internal Revenue Code Section 965 imposes a one-time transition tax on a U.S. shareholder’s share of deferred foreign income of certain foreign corporation’s accumulated deferred foreign income. For this purpose, a U.S. shareholder is a U.S. person who directly, indirectly, or constructively owns at least 10 percent of either the total combined voting power or total value of a foreign corporation’s stock.
The transition tax is treated as a mandatory subpart F inclusion of pre-effective date foreign earnings. Internal Revenue Code Section 965 requires a so-called “deferred foreign corporation” (“DFIC”) to increase its subpart F income in its last taxable year that began before January 1, 2018, by the greater of its “accumulated post-1986 deferred foreign income” as of November 2, 2017 or its accumulated post-1986 deferred foreign income” as of November 2, 2017 or its accumulated post-1986 deferred foreign income as of December 31, 2017. Each of these two dates are earnings and profits (“E&P”) measuring dates. A DFIC is any controlled foreign corporation of a U.S. shareholder that has accumulated post-1986 deferred foreign income greater than zero as of the E&P measurement date.
A deduction may be claimed for a pro rata share of deferred foreign income. The amount of deduction depends on whether the assets of the foreign corporation are liquid or illiquid assets. For individuals, the deferred foreign income deduction may result in a transition tax rate equal to 17.5 percent for deferred income held in currency or currency equivalents or a tax rate equivalent to 9.05 percent on no-cash assets. Foreign tax credits are not allowed to reduce the transition tax liability.
Although the Transition Tax Was Due in 2018, Many Have Yet to Properly Report the Transition Tax
The transition tax is reported on Internal Revenue Service (“IRS”) Form 965 and was due in 2018. Although the transition tax inclusion was required to be disclosed to the IRS in 2018, a significant number of foreign corporate shareholders have not timely reported the transition tax inclusion to the IRS or have made any transition tax payments to the IRS. This is understandable because in many cases, the transition tax is substantial. The problem is that the IRS has begun to send out “soft letters” to individual shareholders reminding foreign corporate shareholders of their transition tax obligations. The next logical step will be for the IRS to begin auditing shareholders and assessing the transition tax along with all applicable penalties. Given the potential large tax liability associated with the transition tax, some have asked if it is possible to further defer the transition tax. Below, we will discuss how even a delinquent transition tax can still be deferred.
Deferring and Possibly Reducing the Transition Tax
A Section 962 election offers individual shareholders of foreign corporations with a transition tax liability tax planning options. An individual shareholder can reduce a transition tax utilizing precious foreign tax credits. Generally, only U.S. shareholders that are C corporations are eligible to reduce subpart F inclusions utilizing Section 960 indirect foreign tax credits. However, individual shareholders can claim a Section 962 election to be treated as a C corporation for purposes of claiming indirect foreign tax credits with respect to the transition tax. However, the Section 962 comes at a cost. If an individual makes a Section 962 election for purposes of the transition tax, the individual will be effectively taxed at the U.S. corporate tax rates (under the 2017 tax year marginal rates). The 2017 corporate rates can be much greater than the standard transition tax rates discussed above.
The federal income tax consequences of a U.S. individual making a Section 962 election is as follows. First. The individual is taxed on amounts in his gross income under corporate tax rates. Second, the individual is entitled to a deemed-paid foreign tax credit under Section 960 as if the individual were a domestic corporation. Third, when the foreign corporation makes an actual distribution of earnings that has already been included in the gross income by the shareholder under Section 951(a), the E&P must be included in the gross income of the shareholder again to the extent they exceed the amount of the U.S. income tax paid at the time of the 962 election. In certain cases the 962 election will not only result in the shareholder recognizing indirect foreign tax credits that are economically advantageous, but there may be an opportunity to defer a certain portion of the transition tax until actual receipt of the E&P.
Although a 962 election generally should, pursuant to the regulations, be made with a taxpayer’s timely filed tax return for the year the election relates, See Treas. Reg. Section 1.962-3(b). at least one federal court has allowed a “late” Section 962 election. See Dougherty v. Commissioner, 60 T.C. 917 (1973). Thus, there is authority which allows foreign corporate shareholders the ability to make a late Section 962 election on a delinquent transition tax. Anyone who believes that they owe a transition tax or needs assistance in planning to minimize the transition tax, should consult with a qualified international tax attorney.
Anthony Diosdi is one of several international tax attorneys at Diosdi Ching & Liu, LLP. As an international tax attorney, Anthony Diosdi provides international tax advice to closely held and publicly traded entities. Diosdi Ching & Liu, LLP has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.