The IRS has issued highly anticipated final regulations under Internal Revenue Code Section 965, the transition tax provision added by the Tax Cuts and Jobs Act. Sec. 965 generally requires U.S. shareholders to pay a “transition tax” on the untaxed foreign earnings of certain specified foreign corporations as if those earnings had been repatriated to the United States.

For a summary of the changes brought forth under the final regs, see our article “Finalized Section 965 transition regs: An overview.” Here we’ll focus on adjustments to earnings and profits (E&P) and basis, as well as the application of Sec. 986(c) dealing with previously taxed E&P.

Deferred foreign income corporations

Sec. 965 imposes a transition tax on untaxed foreign earnings of foreign subsidiaries of U.S. companies by deeming those earnings to be repatriated. More specifically, Code Sec. 965(a) provides that, for the last tax year of a deferred foreign income corporation (DFIC) that begins before January 1, 2018 (such year of the DFIC, the “inclusion year”), the subpart F income of the corporation (as otherwise determined for such tax year under Code Sec. 952) is increased by the greater of:

  • The accumulated post-1986 deferred foreign income of such corporation determined as of November 2, 2017, or
  • The accumulated post-1986 deferred foreign income of such corporation determined as of December 31, 2017 — each such date, a “measurement date,” and the greater of the accumulated post-1986 deferred foreign income of the corporation as of the measurement dates, the “Code Sec. 965(a) earnings amount.”

Furthermore, under Sec. 965(b)(1), the Sec. 965(a) earnings amount that would otherwise be considered under Sec. 951(a)(1) by a U.S. shareholder with respect to a DFIC is reduced by the amount of such U.S. shareholder’s aggregate foreign E&P deficit, which is allocated to such DFIC under Sec. 965(b)(2). The Sec. 965(a) earnings amount reduced as described in the preceding sentence is referred to in IRS guidance as the “Code Sec. 965(a) inclusion amount.”

For purposes of Sec. 965, a DFIC is any specified foreign corporation of a U.S. shareholder that has accumulated post-1986 deferred foreign income (as of a measurement date) greater than zero.

Controlled foreign corporations

Sec. 965(e)(1) provides that the term “specified foreign corporation” means any controlled foreign corporation (CFC), and any foreign corporation with respect to which one or more domestic corporations is a U.S. shareholder.

Under Sec. 957, a CFC is a foreign corporation for which:

  • More than 50% of the total combined voting power of all classes of stock is entitled to vote, or
  • The total value of the stock of the corporation is owned (directly, indirectly or constructively) by U.S. shareholders.

A U.S. shareholder for CFC purposes is a U.S. citizen who owns 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation.

Sec. 951(a)(1) provides that every person who is a U.S. shareholder of a CFC, as defined in Code Sec. 951(b), and who owns stock in such corporation on the last day in the CFC’s tax year, must include in his or her gross income, subject to exceptions not relevant here, the amount determined under Code Sec. 956 with respect to such shareholder.

Under Sec. 959(a)(1), distributions of previously taxed E&P are excluded from the U.S. shareholder’s gross income. Meanwhile, Sec. 961 provides rules with respect to adjustments to basis of stock in CFCs. Sec. 961(b)(2) provides that, to the extent that an amount excluded from gross income under Sec. 959(a) exceeds the adjusted basis of the stock or other property with respect to which it’s received, the amount is treated as gain from the sale or exchange of property.

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Ordering rule

Proposed regs issued in 2018 contain rules relating to adjustments to E&P and basis to determine and account for the application of Sec. 965(a) and Sec. 965(b), as well as a rule that limits the amount of gain recognized in connection with the application of Sec. 961(b)(2).

The proposed regs also set forth an ordering rule for the last tax year of a specified foreign corporation that begins before January 1, 2018, and the tax year of a U.S. shareholder in which or with which such year ends. The rule relates to adjustments to E&P for purposes of determining a U.S. shareholder’s inclusions under Sec. 951(a)(1) and the treatment of distributions under Sec. 959.

The IRS has determined that the ordering rule’s limited application to E&P for a specified foreign corporation’s last tax year beginning before January 1, 2018, is too narrow given that it’s intended to apply for purposes of determining post-1986 E&P and accumulated post-1986 deferred foreign income on the E&P measurement date on November 2, 2017; that measurement date may not fall within a specified foreign corporation’s last tax year beginning before January 1, 2018. The final regs address this issue by providing that the ordering rule applies for the tax year of a specified foreign corporation in which an E&P measurement date occurs, as well as for the last tax year of a specified foreign corporation that begins before January 1, 2018.

The final regs provide rules concerning the ordering of the determination of foreign income taxes deemed paid with respect to an inclusion or distribution, after the E&P adjustments are determined in accordance with applicable regulations. The final regs provide that, for purposes of determining the consequences of a dividend (under the deemed foreign tax paid credits of Former Sec. 902 and Sec. 960) or an inclusion under Sec. 951(a)(1), respectively, the ordering rule applies. However, there’s an exception: Former Sec. 902 is applied with respect to any distributions from the specified foreign corporation described in applicable regulations that aren’t disregarded under other applicable regulations before Sec. 960 is applied with respect to an inclusion or a distribution described in applicable regulations.

Other E&P implications

Sec. 986(c) provides rules with respect to foreign currency gain or loss on distributions of previously taxed E&P attributable to exchange rate movements between the times of deemed and actual distribution.

In addition, the final regs state that the other rules of Former Sec. 902 and Sec. 960 apply. The final regs also provide that the E&P consequences of a distribution between specified foreign corporations disregarded for purposes of Code Sec. 965 pursuant to applicable regulations are determined after adjustments for Sec. 965(a) inclusions while the consequences of other distributions are determined.

Sec. 1248 provides a rule under which a U.S. person includes in gross income as a dividend (out of the CFC’s untaxed accumulated E&P) any gain recognized on the sale or exchange of a foreign corporation’s stock that was a CFC during a specified period. The final regs include a provision regarding the proper points at which to determine and take into account inclusions under Sec. 1248 with respect to the Sec. 965 rules.

Adjustments to the E&P of DFICs

Under proposed regulations, the E&P described in Sec. 959(c)(2) — a rule for determining whether any portion of a distribution is tax-free under Code Sec. 951(a) — of a DFIC are increased by an amount equal to the reduction to a U.S. shareholder’s pro rata share of the Sec. 965(a) earnings amount of the DFIC under Sec. 959(b), “provided the U.S. shareholder includes the Code Sec. 965(a) inclusion amount with respect to the deferred foreign income corporation in income.”

Because the rule was intended to limit the availability of Sec. 965(b) previously taxed E&P to situations in which a Sec. 965(a) inclusion amount was included only if there was a Sec. 965(a) inclusion amount, the rule is revised to so clarify.

Also, the final regs clarify that Sec. 965(b) previously taxed E&P are treated as E&P attributable to an amount previously included in the income of a person under Sec. 951 for purposes of Sec. 1248(d)(1).

Basis election

The proposed regs provided that, in general, no adjustments to basis of stock or property are made under Sec. 961 (or any other provision of the Code) to account for the reduction of a U.S. shareholder’s pro rata share of the Sec. 965(a) earnings amount of a DFIC by a portion of its aggregate foreign E&P deficit.

In addition, an election under the proposed regs allows a U.S. shareholder’s basis in the stock of a DFIC or applicable property with respect to the DFIC to be increased by an amount equal to the Sec. 965(b) previously taxed E&P of the DFIC with respect to the U.S. shareholder. If the relevant return was due before September 10, 2018, the proposed regs provide that the basis election had to be made by October 9, 2018 (the “transition rule”).

The final regs provide that the transition rule will apply with respect to returns due (regardless of any extension) before 90 days after the regs are published in the Federal Register. In such cases, the basis election must be made no later than 90 days after the regs are published.

Additionally, the final regs provide that, if a basis election was made when or before the regs were published, the basis election may be revoked by attaching a statement to an amended return filed no later than 90 days after the regs are published.

Application of Sec. 986(c)

The proposed regs provide that, for purposes of Code Sec. 986(c), foreign currency gain or loss with respect to distributions of Sec. 965(a) previously taxed E&P would be determined based on movements in the exchange rate between December 31, 2017, and the date on which such E&P were distributed. The final regs provide an additional rule that would prevent gain recognition attributable to fluctuations in exchange rates.

Complexities to consider

The finalized Sec. 965 regs bring a wide variety of complexities for U.S. shareholders with foreign income to consider. If you believe you’re affected, contact your CPA to discuss the implications.

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