The IRS recently released its proposed regulations interpreting Section 965, the provision in the Tax Cuts and Jobs Act (TCJA) that imposes a one-time "transition tax" on the stockpiled earnings of U.S. companies' foreign subsidiaries. The transition tax is effected through a deemed repatriation mechanism. Not surprisingly, Section 965 continues to be a hot topic.

Overview of the Transition Tax

Under prior law, certain income derived from a controlled foreign corporation (CFC) was deemed distributed to its U.S. shareholders and taxable immediately as Subpart F income, even if that income was never actually distributed. The TCJA did not change the Subpart F income rules, but it did tweak the law in one significant way: it changed the ownership attribution rules so that more U.S. taxpayers will find themselves as owners of CFCs, and therefore liable for paying current tax on the Subpart F income of those CFCs. Section 965 addresses CFCs and foreign corporations with a 10 percent U.S. corporate shareholder that has a positive accumulation of foreign earnings, called deferred foreign income corporations (DFICs). Applicable to the last taxable year of a DFIC beginning before Jan. 1, 2018 (i.e., 2017 for a calendar year DFIC), Section 965 requires theses stockpiled earnings to be “deemed repatriated” to 10 percent U.S. shareholders as Subpart F income. Foreign earnings held in cash and cash equivalents are taxed to U.S. corporate shareholders at a 15.5 percent rate, and the remaining earnings are taxed at 8 percent. The tax rates applicable to individual U.S. shareholders are marginally higher.

Proposed Regulations

The IRS released proposed regulations in August 2018 (REG-104226-18) and asked for comments by Oct. 9, 2018. Before the end of the comment period, however, the IRS issued additional guidance that affects certain aspects of the proposed regulations. An overview of the most noteworthy changes in the proposed regulations and more recent IRS guidance are discussed below.

Proposed Regulation Section 1.965-2: Adjustments to Basis

A U.S. shareholder increases its basis in its stock of a DFIC by its pro rata share of the Section 965(a) income of the DFIC. If the U.S. shareholder is a domestic pass-through entity, an owner's tax basis in that entity will be adjusted based on the applicable provisions of the partnership or S corporation rules. In this sense, the proposed regulations imply that owners of a pass-through entity should adjust tax basis in the pass-through entity by the amount of reported Section 965(a) income, but this is not stated explicitly.

In general, no adjustments to the basis of stock in a DFIC are made to take into account the reduction to a U.S. shareholder's pro rata share of Section 958(a) income by reason of allocated deficits from foreign corporations with deficits of earnings and profits (E&P) under Section 965(b). However, the regulations allow a U.S. shareholder to elect to increase its stock basis in the DFIC by the Section 965(b) amount, provided there is a corresponding decrease in the stock basis of E&P deficit foreign corporations, and that these basis adjustments are consistently made with respect to all DFICs and deficit foreign corporations in which the U.S. shareholder owns stock directly or indirectly.

On Oct. 1, 2018, the IRS issued Notice 2018-78 under which the due date for the stock basis election (originally Oct. 9, 2018) is extended to 90 days after the proposed regulations are finalized and published in the Federal Register. The Notice also provides that any basis election made before the regulations are published can be revoked within 90 days after such publication.

Proposed Regulation Section 1.965-4: Anti-Avoidance

The proposed regulations contain anti-avoidance rules consistent with the rules announced in IRS Notice 2018-26, released in March. Under these rules, a transaction is disregarded for Section 965 purposes if:

  • The transaction occurs on or after Nov. 2, 2017,
  • The transaction is undertaken with a principal purpose of changing the amount of a Section 965 element of a U.S. shareholder, and
  • The transaction would (absent this regulation) change the amount of the Section 965 element of the U.S. shareholder.

For more information about this, read our update here.

Proposed Regulation Section 1.965-5 and -6: Foreign Tax Credits

Taxpayers are prevented from taking a foreign tax credit (or deduction) for the "applicable percentage" of foreign taxes paid or accrued with respect to which a Section 965(c) deduction is allowed. This disallowance applies to foreign taxes deemed paid by the taxpayer as well as withholding taxes imposed on distributions of Section 965 previously taxed income. The foreign tax credit disallowance is calculated at the domestic pass-through entity level, rather than the individual owner level, so the pass-through entity must provide its owners with the calculation necessary for them to report their portion of the credit and disallowance.

Proposed Regulation Section 1.965-7: Deferred Payment Elections

Taxpayers can elect to pay their Section 965 liability over an eight-year period (interest-free), rather than in a lump sum in the initial year. The proposed regulations make the following clarifications about this installment election:

  • This election is made at the taxpayer level, meaning a domestic pass-through entity that is a U.S. shareholder of a DFIC cannot make the election on behalf of its owners.
  • Certain events will cause these installment payments to accelerate, including: (1)   the taxpayer ceases to be considered a U.S. person, (2) the liquidation, sale, exchange or other disposition of substantially all of the taxpayer's assets, (3) the cessation of the business by the taxpayer,  or (4) the failure to timely pay  an installment (other than the initial installment).
  • The net investment income tax (NIIT) liability resulting from repatriated income under Section 965 cannot be paid in installments and must be paid immediately.

The proposed regulations provide S corporation shareholders with the ability to defer payment of their Section 965 liability for a length of time that may be indefinite. Thus, shareholders of an S corporation that is a U.S. shareholder in a DFIC can elect to defer payment of their Section 965 tax liability until:

  • The S corporation ceases to do business or ceases to exist,
  • The corporation ceases to be an S corporation,
  • The liquidation, sale, exchange or other disposition of substantially all of the assets of the S corporation, or
  • The shareholder transfers any share of stock in an S corporation (unless the shareholder and an eligible transferee enter into a specified transfer agreement).

The regulations clarify a few things about this election:

  • The election is made by attaching a statement to the taxpayer's return.
  • The taxpayer must annually report the amount of deferred net tax liability until it is fully paid. A taxpayer who fails to report this amount must pay 5 percent of the deferred amount for each year of failed reporting.
  • If the shareholder transfers S corporation stock to an eligible transferee, the transferee can make the same deferral election and the tax payments can continue being deferred.
  • If an event occurs that triggers the end of this deferral period, taxpayers can enter into the eight-year installment payment agreement with the consent of the IRS.

Proposed Regulation Section 1.965-8: Consolidated Groups

Under the proposed regulations, members of a consolidated group are treated as one single U.S. shareholder for certain provisions in Section 965. Not only will this single-taxpayer treatment apply to the election to pay the transition tax in installments, but it will also apply to the election to forego the use of net operating losses (NOLs). The section with perhaps the most impact, though, is that this single shareholder treatment also applies for purposes of allocating aggregated foreign E&P deficits against a DFIC member's Section 965(a) income. Members of affiliated groups will have single-member treatment even if not all taxpayers are members of the consolidated group, which effectively expands this single-member treatment to even more taxpayers. This treatment may pose problems at the state level, because states may not conform to this treatment.

IRS Notice 2018-78 clarifies that in order to prevent the overstatement of the aggregate foreign cash position of a consolidated group member, the final regulations will provide that all members of a consolidated group who are U.S. shareholders of a specified foreign corporation will be treated as a single U.S. shareholder for  purposes of disregarding certain assets in determining such aggregate foreign cash position.

Section 965 and the NIIT

Section 965(c) allows a U.S. shareholder of a DFIC to deduct a portion of the amount included under Section 965(a), effectively lowering the tax rate on the deemed repatriated earnings to the reduced tax rates previously noted.

The NIIT is an additional 3.8 percent tax on certain investment income of wealthy individuals (e.g., interest, dividends, capital gains, rents, royalties, etc.). Typically, deductions allowed for regular income tax purposes are also allowed to be taken against the NIIT to the extent those deductions are allocable to the taxpayer's net investment income. However, the proposed regulations specifically state that the Section 965(c) deduction cannot be applied to the NIIT. 

Extension for Hurricane Florence Victims

Notice 2018-78 also provided taxpayers who were affected by Hurricane Florence with additional time to make  Section 965 electionsor file transfer agreements. Under the Notice, affected taxpayers for whom such elections or transfer agreements are due on or after Sept. 7, 2018, but before Jan. 31, 2019, have until Jan. 31, 2019 to file such elections or transfer agreements.

Finalized Regulations to Come

Temporary and finalized regulations based on the feedback to the proposed regulations are forthcoming, with comments due by Oct. 9, 2018. In the meantime, the proposed regulations provide additional clarity to the manner in which these adjustments should be calculated. For more information on the transition tax and the proposed regulations, please contact us.

Published on October 16, 2018