Most readers have some familiarity by now with new Internal Revenue Code Section 965 and the “deemed repatriation” or “transition tax” introduced by the Tax Cuts and Jobs Act (“TCJA”). Introductory detail about this new “one-time” tax can be found at my prior blog posts here and here. Generally speaking, the amount of transition tax is the “US shareholder’s” proportionate share of untaxed and undistributed earnings & profits (E&P) accumulated in every so-called Deferred Foreign Income Corporation (“DFIC”) since 1987, and multiplied by the applicable tax rate as specified by the new law. The US shareholder’s proportionate amount of this E&P is included in the shareholder’s income as a new category of Subpart F income in the 2017 tax return.
For those needing a bit more introductory information, a DFIC is a “Specified Foreign Corporation” (SFC) with positive accumulated, untaxed post-1986 E&P determined as at November 2, 2017, or December 31, 2017 (whichever is greater). A SFC is any “Controlled Foreign Corporation” (CFC) as well as any foreign corporation that has one or more domestic corporations as a US shareholder.
Not every US person (e.g., a US citizen, green card holder; any US entity) will be treated as a “US shareholder” for purposes of the transition tax. The shareholder must own (or be “considered as owning” under certain constructive ownership rules) 10% or more of the DFIC.
Today’s post examines the steps needed to figure out the transition tax and the approximate professional costs to get the job done.
Step One: Pinpoint the Entities
- Each and every foreign corporation in which a US taxpayer has an ownership interest must be examined to determine if the corporation is a DFIC and if the taxpayer has the requisite 10% ownership interest.
- This may sound simple, but as my readers know, anything in the US tax law is not as simple as it may first appear. TJCA made changes to the definition of a CFC. Under the new law, a CFC is any foreign corporation in which more than 50 percent of the total combined vote or value of the corporation’s stock is owned directly, indirectly, or constructively by US shareholders on any day during the taxable year of the foreign corporation. This change is effective for taxable years of foreign corporations that begin after December 31, 2017. The transition tax, embodied in Code section 965, applies to the “last taxable year of a [DFIC] which begins before January 1, 2018”. This means the old definition of CFC, rather than the new one, is used for Code Section 965 purposes.
- Careful examination of the constructive ownership rules must be undertaken to see if the 10% ownership threshold is satisfied. Just so you get a general idea how these rules work, here’s a simplified overview: An individual is considered to own all the stock owned by his or her parents, grandparents, spouse, children; partners in a partnership will be treated as owning their proportionate share of stock in any foreign corporations that are owned by the partnership; corporations will be treated as owning their share of stock in any foreign subsidiaries; trust and estate beneficiaries are considered to own their share (not easy to figure out) of foreign corporations owned by the trust or the estate.
Step Two: Figure Out How Much E&P is Subject to Transition Tax
You may want some Imigran on hand as you undertake this part of the analysis. A few pointers –
- This analysis must be done for each DFIC in which the taxpayer has the required 10% ownership interest.
- Each DFIC’s untaxed post-1986 E&P balance is to be determined as at November 2, 2017, and December 31, 2017. Use the E&P balance that is greater. Please see IRS Notice 2018-13 which explains that regulations will be forthcoming that permit US shareholders to make an election to use an “alternative method” to compute the accumulated post-1986 E&P using an October month-end. Special rules will also be provided for applying the alternative method to corporations that have 52- to 53-week taxable years.
- Each DFIC’s E&P must be determined using US tax rules and generally accepted accounting principles (GAAP). This means you cannot simply take the financial statements of the DFIC and look at its retained earnings to find your answer. The determination of E&P is affected by numerous corporate transactions that must be examined, including payment of dividends and sales or redemptions of shares. Dividends paid in 2017 will not reduce the DFIC’s 2017 E&P because of an express provision contained in Code section 965.
- Remember, the transition tax is calculated on the “US shareholder’s” proportionate share of untaxed and undistributed E&P. You will have to carefully examine if any of the undistributed E&P of each DFIC may have been previously taxed under various US rules (e.g., Subpart F), and exclude these amounts. Post-1986 E&P are currently tracked on Schedule J of IRS Form 5471. Therefore, Schedule J may be a helpful short-cut method to calculate the amount of income subject to the transition tax.
- If any of the corporations relevant to the analysis have losses, then special (highly complicated) rules will apply. Generally, a DFIC’s accumulated untaxed post-1986 E&P amount is reduced by any aggregate post-1986 E&P deficits, measured as of the testing date of November 2, 2017, of “E&P deficit foreign corporations” (EDFCs) allocated to the particular US shareholder. If losses are involved in any of the corporations, I suggest you take an Imigran and carefully read the IRS guidance given to date about EDFC’s as contained in Notice 2018-13. The Notice describes regulations that will clarify, for example, that a foreign corporation that is a DFIC may not also be an EDFC, even if it can otherwise meet the EDFC definition. A foreign corporation that may be classified as either a DFIC or an EDFC with respect to a US shareholder that has an accumulated post-1986 E&P deficit as of November 2, 2017 (the EDFC testing date), will be treated as a DFIC and not an EDFC if it has positive post-1986 accumulated deferred foreign income as of December 31, 2017. Other examples with EDFCs are provided that demonstrate just how complex this area really is.
Remember to repeat this process for every DFIC pinpointed in Step 1. For each DFIC, use the greater balance of E&P as of the two prescribed measurement dates: November 2, 2017, and December 31, 2017 (unless the US shareholder had made an election to use an “alternative method” using an October month end).
Step Three: Compute Amount of E&P Supported by Cash and Non-cash Assets
Section 965 contains two tax rates that apply for purposes of the transition tax:
- A higher tax rate applies to E&P supported by a DFIC’s so-called “cash assets” (as discussed below, broadly defined).
- A lower tax rate applies to E&P supported by its noncash assets.
- If the E&P is attributable to cash/cash equivalents it is taxed at a rate of 15.5%; if attributable to noncash or fixed assets it is taxed at a rate of 8%. This is a very simplified explanation of the rule and its ugly details will be more fully described at Step 4.
- Cash assets are defined quite broadly and include more than just “cash”. The higher tax rate applies to numerous assets including cash, the DFIC’s net accounts receivable, and the fair market value of the following assets that are held by the corporation: (i) personal property that is of a type that is actively traded and for which there is an established financial market; (ii) commercial paper, certificates of deposit, securities of the US federal government, and of any US state or foreign government; (iii) any foreign currency; (iv) short-term obligations (i.e., any obligation having a term of less than one year); and (v) any asset economically equivalent to such cash assets as determined by the IRS.
- The way the computation is actually done is quite complicated. The amount of E&P attributable to lower taxed, noncash assets is essentially a residual amount, and it may not apply depending on the particular facts.
Step Four: Calculation of the Transition Tax / Corporate versus Individual Shareholder
- As promised, this is where things get uglier!
- First, let’s review and try to put this into a simple overview explanation so we don’t lose our bearings. The one-time transition tax calculation is meant to work as follows: All post-1986 E&P is included as a new category of Subpart F income to the US shareholder. A deduction is applied to a certain percentage of that income inclusion. The way this deduction works however, yields different results for corporate shareholders and individual shareholders. Other types of shareholders (e.g., a trust, partnership) are not considered in this post.
- For corporate shareholders, the calculations result in an effective tax rate of 15.5% for the portion of E&P supported by cash and cash equivalents, and an 8% rate for other assets. It does not work the same way for individuals since individuals are subject to a higher maximum tax rate in 2017 of 39.6%, as compared to the maximum corporate rate of 35%. Individuals can make a certain election under Code Section 962 to be treated as a corporation for purposes of the transition tax. Assuming the maximum tax rates and not making the election under Code Section 962, the tax rate to an individual shareholder would be 17.54% (15.5% for a corporate shareholder) on accumulated E&P attributable to the corporation’s cash and cash equivalents and approximately 9.05% (8% for a corporate shareholder) on the accumulated E&P attributable to the corporation’s non-cash assets.
- The calculation needs to be done for each taxpayer as the ultimate result will be specific to that individual’s tax bracket.
- Foreign tax credits bring further complexity, the conundrum often referred to as the “grind down” of foreign tax credits. Code section 965(g) reduces certain foreign tax credits that can be taken against the US shareholder’s income inclusion required by section 965. The relevant language from the Code section, “No credit shall be allowed under section 901 for the applicable percentage of any taxes paid or accrued (or treated as paid or accrued) with respect to any amount for which a deduction is allowed under this section.” The details are not discussed here, but “general basket” foreign tax credits may possibly be carried forward (from the prior 10 years) to offset the transition tax. This may also be possible for foreign tax paid in 2018 and carried back to 2017.
- Whether an individual should make the Section 962 election to be treated as a corporate shareholder for purposes of the transition tax is yet another step in an already complex process. Various factors must be considered, not only the factor that making the election may possibly result in a lower transition tax liability.
What Will It Cost?
I’ve canvassed a few tax return preparer colleagues who are struggling through the transition tax calculations. Fortunately, there is now a bit more breathing room for US individuals living and working overseas. The IRS just issued Notice 2018-26 permitting an extension until June 15th for the first installment payment. This extension is for taxpayers who receive an extension of time to file and pay per Treasury Regulation Section 1.6081-5(a)(5) or (6) which includes US persons with tax homes and abodes outside the USA. (See pages 35-36 of the Notice). I will be reading the Notice over the coming week and provide more detail about its contents in a later blog post.
In figuring out the preliminary tax calculations it seems to be taking anywhere from 10 to 40 hours of time, depending on the number of corporations involved and the number of years of accumulated income. The time is being spent on preparing the tax adjustments for post 1986 E&P, determining the value of cash positions and the value of other assets, and calculating an estimate of the deemed repatriation tax. Cost estimates for calculating the transition tax vary widely with the facts of each case, of course. I am hearing estimates for simple cases ranging from $2,000 -$5,000. For clients with multiple entities the estimates are over $5,000-$7,500, not including any interplay with foreign tax issues. More complex cases that could involve multiple corporations some of which may be loss corporations, determining foreign tax credit positions, and involving inflationary currencies and so on, see the range inching up to $30,000.
Update March 23 2019: IRS just updated Q&A regarding 2018 tax return filing and payment obligations arising from the transition tax under Code Section 965
The IRS had earlier issued Q&As (“Questions and Answers about Reporting Related to Section 965 on 2017 Tax Returns”) which provided guidance regarding tax year 2017 return filing and payment obligations arising under section 965 of the Internal Revenue Code. See Questions and Answers about Reporting Related to Section 965 on 2017 Tax Returns. This new IRS document provides answers to questions related to tax year 2018 return filing and payment obligations arising under Section 965 — including reporting and payment obligations resulting from amounts included in income for the 2017 tax year.
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This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute tax advice or a recommended course of action. Professional tax advice should be sought as the information here is not intended to be, and should not be, relied upon by the recipient in making a decision.