Section 965 Transition Tax – Enforcement & Audits Begin Next Month

By now most of my readers will have some familiarity with  Internal Revenue Code Section 965, and the “deemed repatriation” or “transition tax” introduced by the Tax Cuts and Jobs Act (“TCJA”) in 2017.  My earlier blog post provided significant detail about this new tax law provision which is intended to move the US international tax regime into a “territorial system”.  In making the transition, US shareholders of certain foreign corporations, referred to as “deferred foreign income corporations” (DFICs) must pay a one-time “deemed repatriation tax” on the past earnings that have been accumulating over the years in the foreign corporation.  Prior to enactment of the repatriation tax it was possible for foreign companies owned by US persons to defer tax on certain earnings made and held overseas; they would be taxed on such income only upon repatriation of the monies to the United States. New laws, new rules!

Background

A US person (e.g., a US citizen, green card holder; any US entity) that owns (or is “considered as owning” under certain constructive ownership rules) 10% or more of the DFIC (by vote or value) is the party who must pay the transition tax. This “US shareholder” must pay the tax on the shareholder’s pro rata share of certain retained earnings and profits (E&P) of the foreign corporation.  Generally, the tax applies to the corporation’s accumulated E&P (as computed using US tax rules) that have accumulated since 1986. Specifically, the E&P measurement date is the greater of the E&P balance as of November 2, 2017 or, as of December 31, 2017 unless an alternative date is elected. Under the repatriation tax regime, cash holdings in the foreign corporation are taxed at 15.5% and non-cash or non-liquid assets are taxed at 8%.

Enforcement Is Now a Priority for the IRS

The Internal Revenue Service (IRS) has announced that it will begin enforcing Section 965’s repatriation tax in October 2020. October – that is right around the corner. This follows earlier announcements by the IRS Large Business and International (LB&I) Division which announced on July 6, 2020, that a new campaign will examine individuals’ compliance with the transition tax.

Douglas O’Donnell, commissioner of the LB&I Division, explained during an American Bar Association webinar that there will be two treatment streams to approach compliance with the transition tax rules: “One, we are going to send letters to several thousand individuals where we’ve observed the potential for noncompliance and suggest that they take another look and perhaps file an amended return. There’s another group of several hundred where we’re going to actually put them into the audit pipeline because we think that the risk there requires an enforcement intervention.”

Taxpayers in the first group will receive “soft” letters suggesting they review their tax returns and consider whether they need to file amendments.  The agency believes this group of taxpayers may have misunderstood reporting requirements or that they did not obtain all of the information needed to properly determine their tax liabilities.  Taxpayers in the second group will not be treated so gently. They are directly in the audit “pipeline”.

Section 965 calculations are important for both groups of taxpayers.  Not only do the calculations determine the shareholder’s tax liability for the “transition year”, the determinations made under section 965 will have longer term effects. They will impact the corporation’s later treatment of distributions, for example, in determining previously taxed E&P and in claiming foreign tax credits.

Be Proactive

It is expected that LB&I will focus on certain key issues with a taxpayer’s calculation of Section 965 liability. These issues include the calculation of the corporation’s historic earnings and profits; its classification of the company’s assets as cash or non-cash; and the methodology employed to determine taxpayer’s foreign tax credits.

As mentioned, LB&I has already started the campaign process.  Soft letters and examinations will begin next month.  I suggest taxpayers review their transition tax determinations under section 965 and consider  proactive compliance measures in advance. Contact me if you need help.  We work with experts in this area and are happy to assist.

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