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 (TCJA). 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.
The TCJA provides for a shift from the pre-2018 “worldwide” tax system to a “participation exemption system.” Under the old rules, U.S. taxpayers were generally taxed on all income whether earned in the U.S. or abroad, but foreign income earned by a foreign subsidiary of a U.S. corporation wouldn’t be subject to U.S. tax on that income until it was “repatriated” to the United States via dividend. The transition tax effectively bridges the old rules with the new by taxing certain previously untaxed foreign income.
In a specified foreign corporation’s last tax year that began before January 1, 2018, the foreign corporation’s subpart F income is increased by any previously untaxed, noneffectively connected post-1986 earnings and profits (E&P) of the corporation. This is measured as of one of two measuring dates (pre-2018 accumulated deferred foreign income). U.S. shareholders of one or more specified foreign corporations must include in income their pro rata share of the corporation’s pre-2018 accumulated deferred foreign income less their pro rata share of any other specified foreign corporations’ E&P deficits. A U.S. shareholder is allowed a deduction from this amount that results in a 15.5% tax rate for earnings held in cash and liquid assets, and an 8% tax rate on other earnings.
Under Sec. 965(h), taxpayers may elect to pay the transition tax in installments over an eight-year period. Generally, a specified foreign corporation means either a controlled foreign corporation (CFC) or a foreign corporation (other than a passive foreign investment company that isn’t also a CFC) with a U.S. shareholder that’s a domestic corporation.
Sec. 965 applies with respect to the last tax year of certain specified foreign corporations beginning before January 1, 2018, and the amount included in income under this provision is includable in the U.S. shareholder’s year in which or with which such a specified foreign corporation’s year ends. Taxpayers may have had to already pay tax resulting from Sec. 965 when filing their 2017 tax returns. For example, Sec. 965 may have given rise to a 2017 tax liability for a calendar-year U.S. shareholder holding an interest in a calendar-year specified foreign corporation.
Proposed regs under Sec. 965 were published in August 2018. The new final regs retain the basic approach and structure of the proposed regs, with certain revisions. Here are some highlights:
Under Sec. 965(c)(1), a U.S. shareholder of a deferred foreign income corporation (DFIC) that’s required to include a Sec. 965(a) inclusion amount in income may deduct, in the tax year of the inclusion amount, a “Section 965(c) deduction amount” equal to the sum of:
- The shareholder’s 8% rate equivalent percentage of the excess (if any) of the Sec. 965(a) inclusion amount over the amount of such shareholder’s “aggregate foreign cash position,” plus
- The shareholder’s 15.5% rate equivalent percentage of so much of the U.S. shareholder’s “aggregate foreign cash position” as doesn’t exceed the Sec. 965(a) inclusion amount.
The cash position of any specified foreign corporation is the sum of three items:
- Cash held by the corporation,
- The net accounts receivable of the corporation, and
- The fair market value of the certain “cash equivalent” assets held by the corporation, including:
- Personal property that’s of a type actively traded and for which there’s an established financial market,
- Commercial paper, certificates of deposit, the securities of the federal government and of any state or foreign government,
- Any foreign currency,
- Any short-term obligation with a term of less than one year, and
- Other “economically equivalent” assets.
However, the amounts of net accounts receivable, actively traded property and short-term obligations aren’t taken into account by a U.S. shareholder in determining its aggregate foreign cash position to the extent that the shareholder demonstrates to the IRS that these amounts are taken into account by the shareholder with respect to another specified foreign corporation.
The final regs generally retain the definitions of “aggregate foreign cash position” and “cash position” set out in the proposed regs. But the IRS has determined that a narrow exemption from the definition of “cash position” is appropriate for certain assets held by a specified foreign corporation in the ordinary course of its trade or business, as well as for certain privately negotiated contracts to buy or sell such assets.
Accordingly, the final regs provide that a commodity described in Sec. 1221(a)(1) or Sec. 1221(a)(8) in the hands of the specified foreign corporation is excluded from the category of personal property that’s of a type actively traded and for which there’s an established market — except with respect to dealers or traders in commodities. In addition, the final regs exclude forward contracts and short positions with respect to such commodities from the definition of “derivative financial instrument” to the extent that they could have been identified as a hedging transaction with respect to such commodities.
Pro rata share.
Under Sec. 958(a), a U.S. shareholder’s pro rata share of the Sec. 965(a) earnings amount of a DFIC is the portion of the Sec. 965(a) earnings amount that would be treated as distributed to the Sec. 958(a) U.S. shareholder under Sec. 951(a)(2)(A) and other regs. This would be determined as of the last day of the inclusion year of the DFIC. The IRS has determined that this definition is inconsistent with the statutory language of Sec. 951 and Sec. 965 in the case in which a specified foreign corporation, whether it is or is not a CFC, ceases to be a specified foreign corporation during its inclusion year.
Because a specified foreign corporation is treated as a CFC for purposes of Sec. 951, the IRS has determined that the final regs should be consistent with Sec. 951 in requiring a Sec. 965(a) inclusion by such a Sec. 958(a) U.S. shareholder. Accordingly, the definitions of “pro rata share” and “Section 958(a) U.S. shareholder inclusion year” are revised in the final regs.
The proposed regs provided that, for purposes of determining a Sec. 958(a) U.S. shareholder’s pro rata share of a specified E&P deficit of an E&P deficit foreign corporation, the specified E&P deficit is allocated among the shareholders of the corporation’s common stock in proportion to the value of the common stock held by such shareholders.
The IRS has determined that a specified E&P deficit should be allocated to shareholders of an E&P deficit corporation’s preferred stock in cases involving common stock with no liquidation value. Accordingly, the final regs provide that any amount of a specified E&P deficit that would otherwise be allocated in a hypothetical distribution to a class of common stock that has no liquidation value is instead allocated to the most junior class of equity with a positive liquidation value to the extent of the liquidation value.
The final regs also provide that, in cases in which a corporation’s common stock has a liquidation value of zero and there’s no class of equity with a liquidation preference relative to the common stock, the specified E&P deficit is allocated among the common stock using any reasonable method consistently applied.
Attribution rules in determining a specified foreign corporation.
The proposed regs provided a special attribution rule in determining whether a foreign corporation is a specified foreign corporation solely because of downward attribution of its stock under Sec. 318(a)(3)(A) from a partner to a partnership when the partner has only a de minimis interest in the partnership. The IRS notes that downward attribution of stock to a trust from de minimis beneficiaries of the trust presents similar administrative and compliance difficulties to those addressed in the proposed regs. Accordingly, the final regs extend the special rules concerning downward attribution (as modified) to trusts.
In addition, the final regs increase the threshold for application of this special attribution rule for partnerships from 5% to 10%. Similarly, the final regs use a 10% threshold for the newly added special attribution rule for trusts.
The final regs retain the applicability dates that were in the proposed regs and generally apply beginning the last tax year of a foreign corporation that begins before January 1, 2018, and, with respect to a U.S. person, beginning the tax year in which or with which such tax year of the foreign corporation ends.
The recently finalized Sec. 965 transition regs bring important changes to the taxation landscape for U.S. taxpayers with foreign income. Work closely with your CPA to determine how the changes may affect your situation.