The IRS has provided additional foreign earnings transition tax guidance. The IRS first issued guidance for computing the “transition tax” on the untaxed foreign earnings of U.S. companies’ foreign subsidiaries in Notice 2018-7, I.R.B. 2018-4, 317. The transition tax was enacted as part of the Tax Cuts and Jobs Act (Act) (P.L. 115-97). In addition, The IRS provides guidance about the repeal of Code Sec. 958(b)(4) by the Act.
Generally, new Code Sec. 965 imposes a transition tax on the untaxed foreign earnings of U.S. companies’ foreign subsidiaries by deeming those earning repatriated. Foreign earnings held in cash and cash equivalents are taxed at a 15.5 percent rate. The remaining earnings are taxed at an 8 percent rate. In most cases, the transition tax may be paid in installments over an eight-year period. Code Sec. 965 is effective for the last tax year of foreign corporations that begins before January 1, 2018. It also applies to U.S. shareholders for tax years in which or with which such foreign corporation’s tax years end. Code Sec. 965(a) earnings are not subject to the rules or limitations in Code Sec. 952. Moreover, they are not limited by the accumulated E&P of the deferred foreign income corporation (DFIC) as of the close of the inclusion year.
Foreign Earnings Transition Tax Guidance
The IRS will issue regulations addressing the application of Code Sec. 965. Before a specified foreign corporation (SFC) can be identified as a DFIC or an E&P deficit foreign corporation, it must first be determined whether the SFC is a DFIC. The notice provides guidance on making this determination and includes examples.
In addition, the notice provides an alternative method for calculating post-1986 E&P. According to the guidance, the specified foreign corporation’s actual post-1986 E&P must be determined as of the close of both November 2, 2017, and December 31, 2017. However, it is impractical for some taxpayers to determine post-1986 E&P on a date other than the last day of the month. Therefore, the regulations will provide an election to use an alternative method for determining post-1986 E&P. The notice provides examples of the alternative method.
The regulations will also address the allocation of deficits to different classes of stock. When multiple classes of stock are outstanding, specified E&P deficit will be allocated first among the shareholders of the corporation’s common stock and in proportion to the value of that stock.
The regulations will also provide instructions on how to aggregate foreign cash positions and how to treat demand obligations. Further, foreign currency gain or loss with respect to distributions of previously taxed income will be determined based on movements in the exchange rate between December 31, 2017, and the date on which the previously taxes E&P are distributed. Again, examples are provided.
Notice 2018-7 Rules Modified
The IRS will issue regulations that modify Notice 2018-7, which discussed repatriation of earnings subject to the transition tax. The IRS new regulations will clarify how to apply the gain-reduction rule to distributions received from a DFIC through a chain of ownership. Specifically, when a U.S. shareholder receives distributions through a chain of ownership, the gain recognized will be reduced by the inclusion amount of the DFIC’s U.S. shareholder. Similarly, the gain-reduction rule will reduce otherwise recognized gain of any CFC in the ownership chain through which a distribution is made to a U.S. shareholder.
Moreover, the guidance provides taxpayers targeted relief from certain unintended consequences arising from a change to existing stock attribution rules. The IRS will amend the Form 5471 instructions to provide an exception from Category 5 filing for a U.S. shareholder when no U.S. person owns stock in a CFC and the foreign corporation is a CFC only because the U.S. person owns the CFC stock by attribution.
The new regulations will be effective beginning the first tax year of a foreign corporation to which Code Sec. 965 applies. They will apply to U.S. shareholders for the tax years in which or with which such foreign corporations’ tax years end. Taxpayers may rely on the rules in the notice until the new regulations are issued.
Also, taxpayers may rely on section 5.01 of this notice with respect to a foreign corporations’ last tax year beginning before January 1, 2018. In addition, U.S. shareholders may rely on this guidance for tax years in which or with which such foreign corporations’ tax years end, pending further guidance. Any future guidance will be prospective.
Before the IRS changes Form 5471 instructions, taxpayers may also rely on the exception described in the notice for the last tax year of foreign corporations beginning before January 1, 2018, and each subsequent year of such foreign corporations and for the tax years of U.S. shareholders in which or with which such foreign corporations’ tax years end.
The Treasury and the IRS request comments on the rules described in the notice. In addition, the IRS wants to know what additional guidance will assist taxpayers in computing the transition tax. Submit written comments to the Office of Associate Chief Counsel (International), Attention: Leni C. Perkins, Internal Revenue Service, IR-4549, 1111 Constitution Avenue, NW, Washington, D.C. 20224. Alternatively, taxpayers may submit comments electronically to Notice.firstname.lastname@example.org.