On Aug. 1, 2018, the Department of the Treasury and the Internal Revenue Service issued proposed regulations implementing Internal Revenue Code Section 965 as amended by the Tax Cuts and Jobs Act. The proposed regulations provide guidance related to the IRC Section 965 transition tax, which is a one-time tax levied on U.S. shareholders of certain specified foreign corporations on the deemed repatriation of the previously untaxed foreign earnings of the SFC. The Treasury and the IRS previously issued administrative guidance relating to Section 965 after the enactment of the Act. The proposed regulations incorporate most of the rules included in these Notices, with certain modifications, and provide additional rules. Numerous comments were provided seeking relief for U.S. individual shareholders from the provisions of Section 965. However, in the Preamble, the Treasury and the IRS pointed to the clear language of the statute and legislative history, indicating a clear intent for Section 965 to apply to all U.S. shareholders and determined that providing the requested relief wasn’t appropriate. The Preamble also confirmed that no deduction or credit is allowed for any foreign withholding taxes that may apply on an actual repatriation of the foreign income.
Pursuant to Section 965, a transition tax is imposed on the previously untaxed post-1986 foreign of certain SFCs, including all controlled foreign corporations and all foreign corporations (other than passive foreign investment companies) with a 10 percent corporate U.S. shareholder, as if those earnings had been repatriated to the United States. This deemed repatriation of the untaxed foreign E&P results in an income inclusion for the U.S. shareholder of the SFC. These rules were put in place to harmonize all taxpayers prior to the implementation of the new participation exemption and modified territorial tax system resulting from the Act.
The mechanics of the transition tax are that the subpart F income of the foreign corporation is increased by the greater of the accumulated post-1986 untaxed income of the foreign corporation measured at either Nov. 2, 2017 or Dec. 31, 2017. An SFC that’s accumulated post-1986 deferred foreign income greater than zero is a deferred foreign income corporation. The Section 965 inclusion is for the last tax year of an SFC beginning before Jan. 1, 2018 and is determined without regard to any dividends paid during the taxable year.
Under Section 965, a U.S. shareholder is allowed to reduce the amount of the Section 965 inclusion based on deficits in its E&P with respect to other SFCs. The Section 965 inclusion is subject to tax at reduced rate of 15.5 percent with respect to cash and cash equivalent E&P and 8 percent with respect to the remaining amount of inclusion. The effective tax rates are adjusted via a participation exemption, under which a U.S. shareholder is allowed a deduction against its subpart F inclusion. A reduced foreign tax credit also applies to the Section 965 inclusion. While the effective tax rates for individuals may be higher than the 8 percent and 15.5 percent rates for corporations, an election under Section 962 would bring the effective tax rates for individuals down to the corporate levels. Taxpayers generally may elect to pay the tax liability with respect to a Section 965 inclusion in installments over an 8-year period.
The proposed under Section 965 are separated into the following nine sections:
General rules and definitions. Section 1.965-1 provides general operative rules and definitions. Notably, a new rule related to domestic partnerships provides that a controlled domestic partnership will be treated as foreign for purposes of Section 965; provided that the CDP is foreign and the CDP is a U.S. shareholder of an SFC. The SFC would continue to be an SFC, and at least one U.S. shareholder of the SFC would be treated as owning the stock owned by the CDP through another foreign corporation that’s a direct or indirect partner in the CDP.
Adjustments to E&P and basis. Section 1.965-2 provides rules for adjusting the E&P of DFICs, adjusting a U.S. shareholder’s tax basis in DFIC stock and reducing gain when a U.S. shareholder receives distributions from a DFIC attributable to Section 965(c).
Deductions under Section 965(c). Section 1.965-3 provides that, for purposes of calculating the aggregate foreign cash position of the DFIC, certain intercompany obligations between related SFCs are disregarded. The proposed regulation also provides rules that seek to prevent the double-counting of certain assets, such as actively traded property, when determining the U.S. shareholder’s pro rata share of the cash position of another SFC.
Disregarded transactions. Section 1.965-4 sets forth various anti-avoidance rules under which: (1) certain transactions undertaken with a principal purpose of reducing the amount of the Section 965 transition tax, (2) any change in accounting method made for an SFC during a year ending in 2017 or 2018, (3) any entity classification election filed on or after Nov. 2, 2017, and (4) transactions occurring between the two measurement dates are disregarded for purposes of Section 965.
Foreign tax credits. Sections 1.965-5 and 6 provide rules regarding foreign tax credit, as well as rules coordinating the provisions of Section 965 with the foreign tax credit provisions in effect prior to repeal or amendment by the Act.
Elections and payments. Section 1.965-7 provides various rules related to certain elections that taxpayers may make with respect to Section 965. For example, under Section 965(h), any person with a Section 965 tax liability may elect to pay the transition tax in installments over 8 years. The proposed regulations also clarify procedural rules for S corporation shareholders for Section 965(h) elections and related issues. A U.S. shareholder of a DFIC may also elect, under Section 965(n), to not apply a net operating loss deduction. There’s also a regulatory election to use an alternative method to determine the post-1986 E&P of an SFC. The proposed regulations also provide some relief when an installment obligation is underpaid for reasons other than neglect, fraud or intentional disregard, by allocating the deficiency to further installments, rather than causing a full acceleration event, under which the unpaid portion of the remaining installments would become due on the date of the event. Additionally, the proposed regulations include procedural rules for the transfer of a Section 965 obligation to another taxpayer in lieu of a full acceleration of the tax due.
Affiliated groups. Section 1.965-8 provides several rules for applying Section 965 to U.S. shareholders of an SFC that are members of a consolidated group. Specifically, all members of a consolidated group that are U.S. shareholders will be treated as a single U.S. shareholder for certain purposes, such as the election to pay the Section 965 transition tax in installments and the election to forgo the use of NOLs. However, this single U.S. shareholder treatment doesn’t apply for certain purposes, such as determining the Section 965 inclusion.
Effective date. Section 1.965-9 provides that the proposed regulations, when finalized, will be effective beginning the last tax year of a foreign corporation that begins before Jan. 1, 2018, or with respect to a U.S. person, the beginning of the tax year in which such tax year of the foreign corporation ends. However, the proposed regulations clarify that the anti-avoidance rules apply regardless of whether the avoidance transaction, the effective date of an entity classification election or the specified payment occurred before those dates.
IRC Sections 962 and 986
The proposed regulations also provide guidance related to Section 962 elections and the application of Section 986(c) in connection with Section 965. Notably, they provide that the Section 1411 3.8 percent net investment income tax is levied against the Section 965 inclusion amount without reduction for the Section 965(c) participation exemption. The proposed regulations also provide a new rule that Section 986(c) (dealing with foreign currency gain or loss recognized on distributions of previously taxed income attributable to exchange rate movements between dates of inclusion and distribution) doesn’t apply to distributions of Section 965 PTI.
The proposed regulations will affect U.S. persons with direct or indirect ownership interests in certain foreign corporations. As many taxpayers will be required to report this Section 965 transition tax with respect to their 2017 tax returns, taxpayers should reexamine their Section 965 computations in light of the new rules and modifications to prior IRS Notices related to Section 965 included in the proposed regulations. While in proposed form, the proposed regulations are nevertheless the most relevant and comprehensive guidance for taxpayers thus far. While more public comments can be expected before the proposed regulations are finalized, the Preamble makes clear that groups of taxpayers with unique circumstances hoping for last minute relief shouldn’t hold their breath.