By Anthony Diosdi
Introduction
For those who advise clients in international tax, the 2018 tax season was not easy. This is partially due to the enactment of the revised Internal Revenue Code Section 965 transition tax. The new Section 965 was enacted by the Tax Cuts and Jobs Act of 2017. Section 965 taxes retained earnings of foreign corporations attributable to U.S. shareholders. This included income which consisted of post-1986 earnings and profits (“E&P”) allocated to U.S. shareholders through complex calculations. As a result of the Section 965 revision, U.S. shareholders of foreign corporations with retained earnings were required to repatriate as much as 31 years of accumulated foreign earnings in a single year. The good news is the tax rate for foreign repatriated earnings is discounted. Shareholders of foreign corporations can pay taxes on deferred foreign earnings over an eight year period, interest free. However, a shareholder must make a timely election to repatriate foreign earnings at a favorable tax rate.
The newly enacted Section 965 presented major difficulties last tax season. First, calculating the Section 965 transition tax is incredibly confusing and difficult. Second, the Internal Revenue Service (“IRS”) did not provide timely clear instructions on how to calculate the tax on the earnings being repatriated. As a matter of fact, much needed guidance regarding calculating the transition tax were not issued until April 6, 2018. To make matters worse, U.S. shareholders of foreign corporations were required to have all their repatriated earnings computed in time for them to pay eight percent of the Section 965 tax liability by April 17, 2017.
This all resulted likely resulted in a perfect storm where many taxpayers have undoubtedly incorrectly calculated their transition tax inclusions or failed to timely repatriate foreign earnings. We will discuss these situations in a future article. The purpose of this article is to discuss the new Section 965 tax and how the transition tax is calculated.
The Basics of Internal Revenue Code Section 965
The 2017 Tax and Jobs Act revised Internal Revenue Code Section 965. The new Section 965 directs U.S. shareholders of foreign corporations or U.S. corporations with foreign interests to make a one-time taxable recognition of deferred foreign earnings. The new Code Section 965 generally requires that, for the last taxable year of a foreign corporation beginning before January 1, 2018, all U.S. shareholders of any CFC or other foreign corporation that is at least 10-percent U.S. owned but not controlled (other than a Passive Foreign Investment Company “PFIC”) is required to include in income their pro rata shares of the accumulated post-1986 deferred foreign income that was not previously taxed. The tax assessed on deferred foreign earnings or income not previously taxed is is known as a “transition tax.”
The transition tax is treated as a mandatory taxable income inclusion. Internal Revenue Code Section 965 requires a “deferred foreign income company” (“DFIC”) to increase its subpart F income (by increasing taxable subpart F income, the deferred foreign earnings becoming subject to U.S. taxation) in its last taxable year that began before January 1, 2018, by the greater of its “accumulated post-1986 deferred foreign income” (“ADFI”) as of November 2, 2017, or its accumulated post-1986 deferred foreign income as of December 31, 2017. See IRC Section 965(a); Prop. Reg. Section 1.965-1(b)(1); 1.965-1(f)(23). A DFIC is any Specified Foreign Corporation (“SFC”) The term SFC includes not only CFCs, but also entities known as 10/50 corporations. (A 10/50 corporation is a foreign corporation in which a U.S. corporation owns at least 10 percent, but not more than 50 percent of the foreign corporation’s stock).
To reduce the tax on the repatriation of deferred foreign earnings, a pro rata deduction is available. The amount of the deduction varies depending upon whether the deferred foreign income is held in the form of liquid or non-liquid assets. See IRC Section 965(c)(2). For corporate shareholders, the deduction results in a reduced rate of tax equal to 15.5 percent (44 percent of 35 percent rate) for the included deferred income held in cash or cash equivalents and an 8 percent (23 percent of 35 percent rate) rate of tax for the remaining portion of the deferred foreign income. For individual shareholders in the highest 2017 tax bracket (39.6 percent), the deduction results in a reduced rate of tax equal to 17.5 percent on cash and cash equivalents and a 9.05 percent rate of tax on non-cash assets (for 2017 calendar year SFCs). For individual shareholders with a fiscal year specified foreign corporation, the tax rate increases to 27.31 percent on cash and cash equivalents and 14.1 percent on non-cash for 2018. The tax liability may be paid out over an eight-year period. A corresponding portion of the foreign tax credit is disallowed, which limits the credit to the taxable portion of the included income.
Individual shareholders are generally eligible for the dividends received deduction under Section 965. However, in most cases, the individual shareholder will immediately be subject to U.S. tax on relevant E&P inclusion. Unless a Section 962 election is made, this inclusion will be taxed at the shareholder’s marginal income tax rates. Under Treasury Regulation Section 1.962-2(a), a Section 962 election may only be made by an individual who is a U.S. shareholder. If a Section 962 election is made, the individual shareholder is taxed at the U.S. effective corporate tax rates. In some cases, the corporate rate may be higher than the individual shareholders’ marginal tax rate. However, the shareholder will be entitled to utilize credit for the indirect foreign taxes paid by the foreign corporation (subject to a Section 78 gross-up calculation which applies to the receipt of foreign dividends from a CFC). This provision increases the income taxable to the shareholder by a pro rata share of the foreign corporate taxes paid by the CFC, but because those taxes are then available for credit against the taxpayer’s U.S. tax liability, a Section 962 election usually results in a significant tax advantage.
The Section 962 election can be made on a year-to-year basis and is made on a timely filed U.S. tax return.
The transition tax does not apply to all U.S. shareholders. Individual shareholders of a subchapter S corporation are able to defer the transition tax indefinitely. In order for shareholders of S corporations to defer the transition tax, they must make a Section 965(i)(1) election with the IRS. If a Section 965(i)(1) is made, the transition tax is deferred until a trigger event occurs. A trigger event, with respect to a Section 965 liability, is whenever the following occurs first: 1) such corporation ceases to be an S corporation; 2) a liquidation or sale of substantially all the assets of such S corporation, a cessation of business by such S corporation, such S corporation ceases to exist, or any similar circumstances; 3) a transfer of any share of stock in such S corporation by the taxpayer.
Calculating the Transition Tax
Step One- Determine if the Shareholder is an Individual Subject to the Section 965 Inclusion
The first step to determine if a 965 tax applies is to determine if a CFC or SFC is subject to the inclusion. The Section 965 tax is imposed only on a “U.S. shareholder.” Internal Revenue Code Section 951(b) defines “U.S. shareholder” as a United States person who owns 10 percent of the voting power of all classes of stock entitled to vote either directly or indirectly (i.e. within the meaning of Section 958(a)), or is considered as owing by applying the rules of ownership of Section 958(b). This code section applies the constructive ownership rules of Internal Revenue Code Section 318(a), which attributes stock between family members and to and from entities. As discussed above, the transition tax in Internal Revenue Code Section 965 also applies to U.S. shareholders of SFSs.
Below, please see Illustration 1. Which demonstrates an example in which a U.S. shareholder held interest in three foreign corporations could be considered a U.S. shareholder for purposes of Section 965.
Illustration 1.
For purposes of illustration 1., a hypothetical U.S. person has an interest in three foreign corporations. Each corporation is a calendar year reporter, and the Section 965 inclusion year is 2017.
| CFC 1 | CFC 2 | CFC 3 | |
| Taxpayer’s ownership percentage | 100% | 50% | 15% |
| Accumulated post-1986 E&P | |||
| 11/2/2017 | $200,000 | ($10,000) | $75,0000 |
| 12/31/2017 | $210,000 | ($25,000) | $60,000 |
| U.S. ECI | $8,000 | ||
| Previously Taxed Income (pre-2017) | $35,000 | ||
| Deemed paid foreign taxes | $25,000 | $10,000 | $22,500 |
| Cash positions | |||
| 12/31/2015 | $50,000 | $8,000 | $15,000 |
| 12/31/2016 | $60,000 | $5,000 | $10,000 |
| 12/31/2017 | $75,000 | $1,000 | $5,000 |
Applying the transition tax rules to illustration 1., the U.S. person in the above hypothetical owns more than 10 percent by vote or value three non-U.S. corporations. Since the U.S. shareholder owns at least 10 percent of each foreign corporation, each corporation will be considered an SFC for purposes of the Section 965 inclusion.
Step Two- Does the SFC have Accumulated Post-1986 E&P or is it Carrying a Deficit on the Balance Sheet?
Internal Revenue Code Section 965 imposes a transition tax on the share of ADFI. Each SFC’s ADFI equals its post-1986 E&P (measured in functional currency) other than that attributable to effectively connected income (“ECI”) or Section 959 PTI (a company’s net earnings prior to tax expenses), determined without regard to any reduction for dividends the SFC distributed during its last taxable year that began before January 1, 2018 other than dividends it distributed to other SFCs. To determine the amount includible by the SFC’s U.S. shareholder, each SFC having an E&P surplus DFIC reduces its ADFI by an allocable share of the post-1986 E&P deficits of the U.S. shareholder’s other SFCs that have E&P deficits (“Aggregate Foreign E&P Deficit”) measured as of November 2, 2017. For the purpose of determining an SFC’s E&P deficit as of November 2, 2017, the SFC includes in its E&P any pre-tax income (“PTI”). The U.S. shareholder allocates its Aggregate Foreign E&P Deficit to SFCs with positive ADFI based on the proportion that the SFC’s ADFI bears to the aggregate ADFI of all of the U.S. shareholder’s SFCs. The U.S. shareholder then translates its Section 965 inclusion from each SFC from functional currency to U.S. dollars at the spot rate (spot rate is the price quoted for immediate settlement of a currency) on December 31, 2017.
After applying the complicated rules discussed above, does the SFC in our example have accumulated post-1986 E&P, or is it carrying a deficit on the balance sheet? Correctly answering this question will require some mathematical computations. Specifically, computations must be done on two different dates (Nov. 2, 2017, and Dec. 31, 2017). The computation does not include U.S. effectively connected income (which is taxed under a different code section), subpart F income (also taxed under another code section), and previously taxed income. The reason a computation must take place on November 2, 2017 is because this is the date the tax bill to Section 965 was introduced in the House of Representatives. The selection of this date was intended to negate any preemptive maneuvers to reduce the earnings of overseas corporations subject to taxation, of the cash position (which dictates the marginal tax rate that will be imposed on offshore corporate earnings), once the bill was public. In addition, the numbers used to calculate the 965 inclusion does not include corporate E&P prior to January 1, 1987 or when the foreign corporation in question could not be classified as an SFC.
After the Section 965 calculations are completed, the amount for the two testing dates are positive, the shareholder will have DFIC. On the other hand, if the computed amounts for the two testing dates are negative numbers, the shareholder will be considered to have deficit foreign corporation.
In regards to the shareholder in illustration 1., the shareholder has a negative adjustment for ECI, PTI, and current year subpart F. However, CFC 1 and CFC 3 have positive E&Ps and would be considered DFICs, while CFC 2 has a negative accumulated post-1986 E&P and is considered an E&P deficit foreign corporation.
Step Three- Calculate the Section 965 Earnings Amount
To calculate the Section 965(a) earnings amounts, multiply each DFIC for the shareholder taking into consideration his or her ownership percentage. This calculation must be done for each testing date. Once the calculation is completed, the greater of the two tested amounts will represent the Section 965(a) earnings amount. As demonstrated in illustration 2., the Section 965(a) earning amounts are $157,000 for CFC 1 and $11,250 for CFC 2 for an E&P total of $168,250.
Below, please see iIlustration 2., which demonstrates the Section 965 earnings amounts.
Illustration 2.
| CFC 1 | CFC 2 | CFC 3 | |
| E&P 11/2/2017 | $200,000 | ($10,000) | $75,000 |
| ECI | ($8,000) | ||
| Pre-2017 PTI | ($35,000) | ||
| 2017 Subpart F | ($10,000) | ||
| Accumulated post-1986 E&P | $147,000 | ($10,000) | $75,000 |
| Taxpayer’s portion of 11/2/2017 | $147,000 | ($5,000) | $11,250 |
| Section 965(a) earning amount | |||
| E&P 12/31/2017 | $210,000 | $60,000 | |
| ECI | ($8,000) | ||
| Pre-2017 PTI | ($35,000) | ||
| 2017 Subpart F | ($10,000) | ||
| Accumulated post-1986 E& | $157,000 | $60,000 | |
| Taxpayer’s portion of 12/31/2017 | $157,000 | $9,000 | |
| Section 965(a) earnings |
Step Four- Calculate the Section 965 Inclusion Amount
The next step is to calculate the Section 965 inclusion amount the Section 965 earnings amounts for each DFIC by the deficit from the deficit CFCs. This is done by using any loss calculated on the November 2 testing date. This must be further prorated to each DFIC to reflect the taxpayer’s ownership percentage.
Expressed formulaically:
Total deficit E&P x accumulated post – 1986 E&P of each deficit CFC divided by Total
accumulated post – 1986 E&P for all CFCs.
Next, subtract the prorated deficit from each DFIC accumulated post-1986 E&P. This calculation will result in the Section 965 inclusion amount. See IRS Notice 2018-13, Exhibit 3. Such a scenario is described in illustration 3. which is based on IRS Notice 2018-13, Exhibit 3.
Illustration 3.
| CFC 1 | CFC 2 | CFC 3 | |
| Internal Code Section 965(a) earnings amount | $157,000 | $11,250 | |
| E&P deficit (aggregate loss amount of 11/2) | ($5,000) | ||
| Allocate E&P deficits | ($4,666) | ($334) | |
| Section 965 inclusion amount of each company | $152,334 | $10,916 | |
| Total Section 965 inclusion amount | $163,250 |
Step 5- Determine the Shareholder’s Aggregate Cash Position
Determining a shareholder’s aggregate cash position requires an apportionment of the Section 965 inclusion amount to the two tax rates of 15.5 percent and 8 percent. Section 965 effectively taxes a corporate shareholder’s share of the SFCs ADFI at 15.5 percent and an individual U.S. shareholder’s share of a calendar year SFC’s ADFI at 17.54 percent to the extent the U.S. shareholder held the ADFI in cash, cash equivalents, or certain other short-term assets (“aggregate foreign cash position” or AFCP); and at 8 percent and 9.05 percent (with a calendar year SFC) for corporate and individual U.S. shareholders, respectively, on the remainder of ADFI. The U.S. shareholder’s AFCP is the greater of the aggregate of the U.S. shareholder’s pro rata share of each SFC’s cash position at the close of the SFC’s last taxable year that began before January 1, 2018; or the average of the aggregate of the U.S. shareholder’s pro rata share of each SFC’s cash position as of the close of the last taxable year of each SFC that ended before November 2, 2017, and as of the close of the taxable year that precedes the last taxable year of each SFC that ended before November 2, 2017.
An SFC’s cash position equals the sum of its cash, accounts receivable net of accounts payable (but not below zero) and applying Internal Revenue Code Section 461 tax accounting principles, fair market value of actively traded financial assets, fair market value of commercial paper, certificates of deposits, government securities, foreign currency, debt with a term of less than one year, and any item economically equivalent to those listed. As discussed above, amounts allocated to the cash portion will be taxed at the higher rate, and the remainder balance will be taxed at the lower rate. The aggregate cash position is the greater balance of cash or cash equivalents as determined using two different dates: December 31 of the inclusion year (generally 2017 for individuals), and the average of December 31 of the two prior years (generally 2015 and 2016). These amounts are prorated to a shareholder’s percentage of ownership for each corporation.
Step Six-Calculate the Foreign Tax Credits
Because the U.S. shareholder includes as subpart F income a portion of its pro rata share of its SFCs’ ADFI, a corporate U.S. shareholder or individual U.S. shareholder who makes a Section 962 election may also take a Section 960 deemed paid foreign tax credit against its U.S. tax liability for the U.S. shareholder’s share of the SFC’s foreign taxes that relate to the Section 965 income. For this purpose, the U.S. shareholder’s deemed paid foreign taxes with respect to each SFC equals the SFC’s tax pool at its fiscal year-end for the last year that began before January 1, 2018, multiplied by the ratio of the SFS’s allocable share of the U.S. shareholder’s ADFI inclusion divided by the SFC’s Section 959(c)(3) E&P at its fiscal year-end for the last year that began before January 1, 2018.
The amount of that FTC is also subject to both a disallowance for the proportion of taxes that relate to the deduction against ADFI to arrive at the appropriate tax rates (described above) and the limitations of Section 904. The disallowed portion of each SFC’s foreign taxes equals the sum of 1) the proportion of the ADFI include as AFCP income (i.e., at the 15.5 percent rate) multiplied by .557 and 2) the proportion of ADFI as non-AFCP income (i.e., at the 8 percent rate) multiplied by .771. If the U.S. shareholder elects to take a credit with respect to any SFS’s foreign taxes, Internal Revenue Code Section 78 requires the U.S. shareholder to gross-up and include as dividend income the deemed paid taxes by the ratio of the U.S. shareholder’s net Section 965 inclusion over the U.S. shareholder’s gross Section 965 inclusion.
The foreign tax credit calculation is expressed by the following formula:
Deemed tax pool x subpart F income divided by (accumulated E&P – PTI)
Step 7- Prepare a “IRC Section 965 Tax Statement” and Tax Return Compliance
For purposes of calculating the transition tax for the 2017 tax year, taxpayers did not file a separate form of schedule to report the Internal Revenue Code Section 965(a) transition tax inclusion or Section 965(b) deduction. Rather, a taxpayer included Section 965 inclusion with its return an “IRC 965 Transition Tax Statement,” signed under penalties of perjury and, in the case of an electronically filed return, in Portable Document Format (.pdf) with a filename of “965 Tax.” The so-called IRC 965 Transition Tax Statement was required to include the following information:
- The taxpayer’s total amount required to be included in income under Section 965(a).
- The taxpayer’s AFCP, if applicable.
- The taxpayer’s total deduction under Section 965(c).
- The taxpayer’s deemed paid foreign taxes with respect to the total amount required to be included in income by reason of Section 965(a).
- The total net tax liability under Section 965.
- The amount of the net tax liability under Section 965 to be paid in installments.
- The amount of the net tax liability under Section 965, the payment of which has been deferred, under Section 965(i).
- A listing of elections under Section 965 or the election provided for in Notice 2018-13 that has been made, if applicable.
The IRS provided a model statement in IRS Q&A # 3 on its website regarding the necessary “Transition Statement.” For purposes of reporting the transition inclusion for the 2018 tax year, taxpayers will likely need to report a Section 965 inclusion on Form 965 entitled “Inclusion of Deferred Foreign Income Upon Transition to Participation Exemption System.” As of this date, the Form 965 is in draft format with no instructions.
Going Forward
Because of the manner in which the transition tax was enacted, a number of U.S. shareholders undoubtedly did not make a Section 965 inclusion last tax season. It still may be possible file an amended 2018 tax return taking into consideration the Section 965 inclusion and requesting prorated installments with the IRS. A request can also be made with the IRS to waive late-payment penalties.
As more and more individuals and business entities invest in foreign businesses, more and more individuals and businesses will become subject to the Section 965 tax. Although calculating the Section 965 tax may seem difficult now, in the very near future, the Section 965 tax and tax regimes similar to 965 will become far more common.
Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: Anthony Diosdi – 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.