Proposed regulations provide rules for determining the Code Sec. 965 transition tax. These rules determine the inclusion amount of a U.S. shareholder of a foreign corporation with deferred foreign income. The tax imposed on the inclusion is referred to as the transition tax. The proposed regulations address the application of the transition tax and reflect previously issued guidance, with some modifications.
These rules apply
- beginning with the last tax year of a foreign corporation that begins before January 1, 2018, and
- with respect to a U.S. person, beginning with the tax year in which or with which the tax year of the foreign corporation ends.
Comment: The document is currently pending placement on public display at the OFR and publication in the Federal Register. The version released may differ slightly when published.
Generally, a foreign corporation’s earnings are not taxed to its U.S. shareholders until the earnings are repatriated as a dividend to its U.S. shareholders. If the foreign corporation earns certain types of income or invests in U.S. property, the U.S. shareholder may be taxed currently.
To combat the incentive for U.S. shareholders to keep their earnings and profits overseas, the Tax Cuts and Jobs Act (P.L. 115-97) enacted a one-time mandatory tax on the untaxed post-1986 earnings and profits of foreign subsidiaries of U.S. shareholders. Earnings held in the form of cash and cash equivalents are taxed at a 15.5 percent rate and remaining earnings are taxed at an 8 percent rate. The transition tax may be paid in installments over eight years.
Code Sec. 965 Transition Tax
Specifically, the transition tax is imposed on U.S. shareholders who own 10 percent or more, by vote, of a deferred foreign income corporation (DFIC). A DFIC is any specified foreign corporation that has a positive amount of accumulated post-1986 deferred foreign income on one of two measurement dates, November 2, 2017, or December 31, 2017. U.S. shareholders include the domestic pass-through owners of a domestic pass-through U.S. shareholder. A specified foreign corporation is either a:
- controlled foreign corporation (CFC), or
- any foreign corporation in which a domestic corporation is a U.S. shareholder.
For the last tax year of the DFIC beginning before January 1, 2018 (the inclusion year), the U.S. shareholder includes as subpart F income, its pro rata share of the greater of the greater of accumulated post-1986 foreign earnings of the foreign corporation on the measurement dates.
Beginning in December 2017, the IRS released the following pieces of guidance that taxpayers could rely on when applying the transition tax:
What Do the Proposed Regulations Cover?
The proposed regulations provide:
- general rules and definitions, including general rules for determining the Code Sec. 965(a) inclusion amount, the Code Sec. 965(c) deduction, and rules for the treatment of certain specified foreign corporations as CFCs and certain domestic partnerships as foreign partnerships;
- rules for adjustments to E&P and basis;
- specific rules for Code Sec. 965(c) deductions;
- rules that disregard certain transactions when applying the transition tax;
- rules related to foreign tax credits that coordinate the transition tax rules and foreign tax provisions prior to repeal by P.L. 115-97;
- rules regarding elections and payments; and
- rules for applying the transition tax to affiliated groups and that treat all U.S. shareholders of a specified foreign corporation in a consolidated group as a single shareholder.
Many of the rules in the proposed regulation are consistent with the guidance previously provided in the Notices. For example, consist with theNotice 2018-26, I.R.B. 2018-16, 480, the proposed regulations address the application of the constructive ownership rules that provide for downward attribution of stock from a partner to a partnership.
Comment. The rules make it difficult to determine if a foreign corporation is a specified foreign corporation. Thus, stock owned directly, or indirectly by, or for, a partner is not owned by the partnership when the partner owns less than five percent of the partnership’s capital and profits interests.
Rules Consistent With Earlier Guidance
Some additional rules in the proposed regulations that are consistent with the Notices include:
- rules that require that the status of specified foreign corporation as a DFIC be determined before its status as an E&P deficit corporation;
- cash measurement dates and pro rata share rules;
- rules addressing the treatment of derivative financial instruments for purposes of measuring the cash position of a specified foreign corporation;
- definitions of accounts payable and accounts receivable and loans treated as short-term, for determining the cash position of a specified foreign corporation;
- foreign currency rules, including that the accumulated post-1986 deferred foreign income of the specified foreign corporation as of each of the measurement dates must be compared in the functional currency of the specified foreign corporation and use of the spot rate for translating amounts taken into account;
- rules for preventing double counting the aggregate foreign cash position and preventing double counting and non-counting in computing deferred earnings for amounts paid between related parties and measurement dates;
- anti-avoidance rules disregarding certain transactions and rules disregarding certain changes in accounting methods and entity classification elections;
- rules on the Code Sec. 962 election for an individual to be taxed as a corporation; and
- clarification of the interaction between the transition tax and the previously taxed income rules.
Rules for Making Elections
Also, the proposed regulations provide rules for making the following transition tax elections:
- the election to pay net tax liability in eight installments (Code Sec. 965(h));
- the election by an S corporation shareholder to defer a portion of net tax liability (Code Sec. 965(i));
- the election of a real estate investment trust (REIT) to defer tax (Code Sec. 965(m)); and
- the election not to apply the net operating loss deduction (Code Sec. 965(n)).
Because a domestic pass-through owner will take its inclusion into account, the owner may make the elections.
Total Net Tax Liability
The term “total net tax liability” means
- the net tax liability with respect to a person,
- as if the person were a U.S. shareholder of all DFICs with respect to which it has inclusions.
However, dividends excluded include dividends received directly or through a chain of ownership.
Also, the rules provide for proration for underpayments of installments. This allows a deficiency or additional liability to be prorated among the installments in certain circumstances.
Circumstances in which an installment payment will be accelerated are identified, including the sale of substantially all of the assets of a taxpayer and an event that results in a person no longer being a U.S. person. Additionally, an “eligible section 965(h) transferee exception” is provided if the acceleration event is eligible for the exception and the terms of the transfer agreement are met.
Taxpayers may choose to apply the election and payment rules to all tax years as if they were final rules.
Proposed Regulations, NPRM REG-104226-18