By Anthony Diosdi
Recently, the Internal Revenue Service or “IRS” launched a compliance campaign that targets individual compliance with the Section 965 transition tax through examinations and correspondences. The IRS announced it will be expanding Section 965 examinations. This article discusses the 965 transition tax and the use of a 962 election which could significantly reduce a transition tax assessment.
The Section 965 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 of certain foreign corporation’s accumulated deferred foreign income or “ADFI.”
Section 965 generally requires that, for the last taxable year of a foreign corporation beginning January 1, 2018, all “U.S. Shareholders of any controlled foreign corporation or “CFC” or other foreign corporation that is at least 10-percent U.S. owned but not controlled (otherwise known as a Specified Foreign Corporation or “SFC”) must include in income its pro rata share of accumulated post- 1986 deferred foreign income that was not previously subject to federal tax. This assessment is referred to as the “transition tax.”
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 or “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.
Section 965 taxes a foreign corporation’s ADFI at a rate 15.5 percent and an individual’s corporate shareholder at a rate of 17.54 percent to the extent the ADFI is in cash or cash equivalents. Other so-called short-term assets are taxed at 8 percent for corporations and 9.05 percent for individual corporate shareholders. In cases where a foreign corporation is taxed as a fiscal year corporation, for individual shareholders, the transition tax rate increases to 27.31 percent on cash and cash equivalents and 14.1 percent on non-cash assets.
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. However, foreign tax credits are not allowed to reduce the transition tax liability.
The Mechanics of a 962 Election
Under Treasury Regulation Section 1.962-2(a), a Section 962 election may be made by an individual who is a U.S. shareholder of a foreign corporation. If an individual makes a Section 962 election, the individual is effectively taxed at the U.S. corporate tax rates, but the individual is entitled to a credit for the indirect foreign taxes paid by the foreign corporation, by virtue of the mechanics of a Section 78 gross-up calculation that applies to corporate shareholders in receipt of foreign dividends from the foreign corporation (which could be mean a higher marginal tax rate on the Section 965 income). On the other hand, if a U.S. shareholder of a foreign corporation does not make a 962 election, the shareholder is taxed on the transition tax at individual rates. However, the U.S. shareholder of the foreign corporation is not entitled to claim a foreign tax credit for the foreign corporation’s income taxes.
A 962 election allows a shareholder of a foreign corporation an opportunity to continue to defer a portion of the translation tax. The deferral amount depends on the foreign corporation’s amount of foreign taxes it paid prior to the 2018 tax year and foreign currency conversion rates.
Section allows an individual to be subject to tax on subpart F inclusions as if he or she were taxed as a domestic subchapter C corporation. If a 962 election is made, the amounts of subpart F income associated with the transition tax included in the individual’s gross income are treated as if the amounts were received by a C corporation for purposes of applying foreign tax credits under Section 960. A Section 962 election only applies with respect to the E&P of a foreign corporation that is considered subpart F for purposes of the transition tax.
The U.S. federal income tax consequences of a U.S. individual making a Section 962 election are 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 CFC makes an actual distribution of earnings that has already been included in gross income by the shareholder under Section 965 requires that the earnings be included in the gross income of the shareholder again to the extent they exceed the amount of U.S. income tax paid at the time of the Section 962 election. To implement this rule, the regulations describe two categories of Section 962 E&P. The first category is excludable Section 962 E&P (Section 962 E&P equal to the amount of U.S. tax previously paid on amounts that the individual included in gross income under Section 965. The second is taxable Section 962 E&P (the amount of Section 962 E&P that exceeds excludable Section 962 E&P). This second layer of tax is consistent with treating the foreign corporate shareholder the same as if he or he invested in the foreign corporation through a domestic corporation.
Careful modeling should be done to determine if a 962 election will result in a reduction of the transition tax. Any modeling should take into consideration interest and penalty that will result from a transition tax that was due in 2018. The ability to continue to defer a portion of a 965 transition tax can potentially be an extremely valuable tool to reduce or eliminate penalties and interest associated with a late payment of tax.
Unlike many other tax elections that must be timely made with a tax return, a 962 election does not necessarily need to be filed timely with a tax return. At least one case provides that a Section 962 election may be made for the first time in an IRS audit. See Dougherty v. Commissioner, 60 T.C. 917 (1973). Depending on the facts and circumstances of the foreign corporate shareholder and the foreign corporation, a 962 election can be a very effective tool to reduce a 965 transition tax liability. Any foreign corporate shareholder with unsolved transition tax issues should consider whether or not making a 962 election may be beneficial to them.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or 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.