Tax Cuts and Jobs Act: The Toll Charge to Move into the New Quasi-Territorial Regime
On December 22, 2017, the President signed into law the Tax Cuts and Jobs Act (the “Act”). The Act fundamentally overhauls the taxation of individuals, corporations, partnerships, and other multinational enterprises investing in foreign entities under the existing Internal Revenue Code of 1986, as amended (the “IRC”).1
The heart of the international tax reform involves the adoption of a participation exemption regime which transforms the current worldwide taxation system with deferral to a partial territorial system for domestic corporations. The participation exemption regime allows a domestic corporation to deduct from taxable income the foreign source portion of the dividend it receives from its 10% owned foreign corporation. For this purpose, the foreign corporation does not need to be characterized as a controlled foreign corporation (“CFC”). 2 Based on the estimated budget effects of the conference agreement for H.R.1, the participation exemption will save domestic corporations up to approximately USD $223.6B in taxes over 10 years.
In order to facilitate the transition to a participation exemption regime, new Section 965 imposes a one-time transition tax, or toll-charge, on a U.S. Shareholder’s pro-rata share of post-1986 deferred foreign income (the “Mandatory Inclusion”) earned by certain categories of foreign corporations (the “Transition Tax”). While only domestic corporations will benefit from the tax savings from the resulting participation exemption regime, all categories of U.S. shareholders including individuals, partners of domestic partnerships, and shareholders of S corporations will be subject to the toll-charge.
The estimated budget effects of the Act provides that approximately USD $338.8B will be raised as a result of the mandatory repatriation on deferred foreign income. All U.S. investors with investments in foreign corporations should understand the impact that these transition rules will have on their tax filing position for the 2017 and 2018 tax years. This article addresses the impact of the Transition Tax provisions to U.S. investors.
i. Effective Date:
The accumulated post-1986 deferred foreign income of a specified foreign corporation (“SFC”) is included as subpart F income for the last tax year of the SFC beginning before January 1, 2018. A U.S. Shareholder will include its pro-rata share of the Mandatory Inclusion in the tax year with or within which the tax year of the SFC ends.
An SFC’s and its U.S. Shareholder’s tax year ends on December 31, 2017. The SFC will include its post-1986 deferred foreign income as subpart F income for its tax year ending on December 31, 2017. The U.S. Shareholder will include its pro-rata share of the Mandatory Inclusion for the tax year ending on December 31, 2017.
An SFC’s tax year ends on November 30, 2017. The U.S. Shareholder of the SFC has a tax year ending on December 31, 2017.
The last tax year of the SFC beginning before January 1, 2018 is the tax year beginning on December 1, 2017 and ending on November 30, 2018. The SFC will include the Mandatory Inclusion for the tax year ending on November 30, 2018. The U.S. Shareholder will include its pro-rata share of the Mandatory Inclusion for the tax year ending on December 31, 2018.
Generally, Section 898 requires a foreign corporation to adopt the tax year of its majority U.S. Shareholder. In lieu of this tax year, a foreign corporation may elect a one-month deferral by making an election pursuant to Section 898(c)(2).
The proposed regulation to Section 898 provides that a foreign corporation is not required to conform its tax year to the tax year permitted under the statute if it does not have any subpart F income nor receive any actual or deemed distributions. 3 If a foreign corporation had adopted a non-conforming tax year based on this exception, it would now need to conform its tax year for the first tax year subsequent to the tax year that the U.S. Shareholder includes its pro-rata share of the Mandatory Inclusion. 4
ii. The Scope of Section 965: U.S. Shareholders of Specified Foreign Corporations
Under Section 965, a U.S. Shareholder of an SFC is required to include its pro-rata share of the SFC’s post-1986 deferred foreign income as subpart F income. Generally, a U.S. Shareholder is a U.S. person who owns directly, indirectly, or constructively, 10% or more of the total combined voting power of a foreign corporation. 56 A U.S. person for this purpose includes a U.S. corporation, partnership, trust, estate, or a U.S. individual. 7 A U.S. individual includes a U.S. citizen, regardless of his current abode, or a foreign individual meeting the U.S. residency status.
In determining the 10% threshold under this rule, a U.S. person should also consider the revised indirect and constructive ownership rules as a result of the repeal of Section 958(b)(4). As in effect prior to repeal, Section 958(b)(4) provided that the constructive ownership rules under Section 318(a)(3)(A),(B), and (C) were not to be applied so as to consider a U.S. person as owning stock which is owned by a person who is not a U.S. person. The revised constructive ownership rule that removes Section 958(b) is generally effective for the tax year of the Section 965 inclusion. The effect of the repeal would attribute stock owned by a person to a partnership, estate, trust, or corporation in which such person has an interest (“Downward Attribution”). Downward Attribution from a foreign parent in a foreign parented group should be considered in determining the 10% threshold. This dynamic may cause the foreign corporation to be a SFC subject to section 965 because it is now a CFC. In this regard, IRS Notice 2018-13, section 5 should be reviewed.
A domestic corporation owns 5% of the interest of a foreign subsidiary. The remaining 95% of the interest is held by the domestic corporation’s foreign parent. 95% of the interest held by the foreign parent is attributed downward to the domestic corporation and, as a result, the domestic corporation will be deemed to own a 100% of the foreign subsidiary. The foreign subsidiary in the example will be treated as a SFC (see below for definition), and the domestic corporation will be treated as a U.S. Shareholder of the SFC for purposes of Section 965. However, the domestic corporation will only include its pro-rata share (5%) of the deferred foreign income of the foreign subsidiary while it was an SFC.
An SFC is defined under Section 965(e) as (1) CFC and (2) any foreign corporation with respect to which one or more domestic corporations is a U.S. Shareholder (“10% Corporation”). A 10% Corporation is treated as a CFC solely for purposes of taking into account the subpart F income of such corporation under Section 965(a). 8 Passive foreign investment company is excluded from the definition of an SFC. An SFC that is not a CFC is treated as such for the sole purpose of computing the inclusion under the subpart F income rules.
Non-corporate U.S. Shareholders in a non-CFC should request information on the overall ownership makeup of the foreign corporation to determine whether any of the other investors are domestic corporations that meet the 10% ownership threshold (“10% Domestic Corporations”). The existence of a 10% Domestic Corporation will trigger the Section 965 inclusion for all categories of U.S. Shareholders.
All categories of U.S. Shareholders should review their investments in foreign corporations this year and determine if the foreign corporations should be classified as a SFC. If the foreign corporation is an SFC, the U.S. Shareholder should prepare to conduct additional analysis described below.
iii. Rate Equivalent Percentage of the Transition Tax
The rate equivalent percentage applied to the deferred earnings will be lower than the current effective tax rate applicable for all categories of U.S. Shareholders. Section 965 arrives at the lower tax rate by allowing a participation exemption (i.e., a deduction) against the Mandatory Inclusion.
The rate equivalent percentage will depend on the aggregate foreign cash position on the balance sheet of the SFCs. For a domestic corporation that is a U.S. Shareholder, the portion of the deferred earnings that is attributable to the U.S. Shareholder’s aggregate foreign cash position is taxed at a rate equivalent percentage of 15.5%, and the remaining portion is taxed at a rate equivalent percentage of 8%.
The participation exemption allowed to arrive at the respective percentages is the sum of amounts necessary to tax the deferred foreign earnings attributable to the aggregate foreign cash position at 15.5% and the remaining portion at 8% using the highest corporate tax rate in effect for the year of the inclusion. For a calendar-year taxpayer, the amount of the participation exemption allowed on the portion of earnings attributable to its aggregate foreign cash position will be 55.711% and 77.14% for the residual earnings. The participation exemption allowed for a fiscal-year taxpayer should be reduced to reflect the lower corporate tax rate of 21% effective on January 1, 2018.
An SFC’s and the U.S. Shareholder’s tax year ends on December 31, 2017. The U.S. Shareholder will include the deferred foreign income of the SFC for the tax year ending on December 31, 2017. The maximum corporate tax rate for the tax year is 35%. The participation exemption is computed as follows:
|Highest Corporate Tax Rate (Section 11)||
|Participation Exemption Required to Arrive at 15.5% = [(35%-15.5%)/35%]||
|Participation Exemption Required to Arrive at 8% =[(35%-8%)/35%]||77.14%|
The SFC and the U.S. Shareholder of the SFC share a fiscal year-end of November 30, 2017. The U.S. Shareholder will include the deferred foreign income of the SFC for the tax year ending on November 30, 2018.
The maximum corporate tax rate for the 2017 tax year is 35% and the maximum corporate tax rate for the 2018 tax year is 21%. The blended tax rate for the taxpayer is 22.19%.
|Blended Tax Rate Using the Highest Corporate Rate in Effect||22.19%|
|Participation Exemption Required to Arrive at 15.5% = [(22.19%-15.5%)/22.19%]||
|Participation Exemption Required to Arrive at 8% =[(22.19%-8%)/22.19%]||63.95%|
The effective tax on an individual U.S. Shareholder’s deferred foreign earnings may be lower or higher depending on where the individual falls on the tax bracket. For example, presuming the highest individual tax rate of 39.6%, the effective tax rate on the deferred income attributable to the aggregate foreign cash position will be 44.3% x 39.6% = 17.5%. 9 Because the deferred income is included as subpart F income, it does not constitute a qualified dividend and ordinary rates apply.
iv. Aggregate Foreign Cash Position
The aggregate foreign cash position means the greater of (1) aggregate of the U.S. Shareholder’s pro rata share of the cash position of each SFC determined as of the close of the last taxable year that begins before January 1, 2018, or (2) the average of the cash position determined on the last day of each of the two tax years ending immediately before November 2 (the “Cash Measurement Dates”). Further, the statute provides a clear anti-abuse section where the Secretary shall disregard any transactions the principal purpose of which was to reduce the aggregate foreign cash position that may be taken into account. IRS Notice 2018-13 provides that the aggregate foreign cash position of an SFC with respect to any Cash Measurement Date should be expressed in U.S. dollars using the spot rate on the relevant Cash Measurement Date.
The cash position is defined as the cash and foreign currency held by such foreign corporation, the net accounts receivable 10 of such foreign corporation, plus the fair market value of the personal property that is actively traded in an established financial market, commercial paper, certificates of deposit, the securities of the federal government and of any state or foreign government, any short-term obligation of less than one year, and a catchall position that the Treasury identifies as being economically equivalent to any asset described as a cash position. Short-term obligation includes a loan that must be repaid on demand of the lender (or that must be repaid within one year of such demand). 11 With respect to a U.S. Shareholder, any receivable or payable of an SFC from or to a related SFC will be disregarded to the extent of the common ownership of such SFCs by the U.S. Shareholder.
IRS Notice 2018-07 provides that the IRS will issue regulations that will provide that the cash position of any SFC will include the fair market value of each derivative financial instrument held by the SFC that is not a “bona fide hedging transaction.” The Treasury department and the IRS are considering whether future guidance should exclude derivative financial instruments that are not actively traded or that do not reference a cash equivalent asset as described in Section 965(c)(3)(B) from the cash position.
The cash position of an SFC can be excluded if the U.S Shareholder demonstrates that the amount is already taken into account by the U.S. Shareholder with respect to another SFC. Generally this situation will arise if a U.S. Shareholder owns multiple SFCs with different taxable years.
USP, a calendar-year taxpayer, wholly owns CFC1, which has an inclusion year ending on December 31, 2017, and CFC2, which has an inclusion year ending on November 30, 2018. USP’s pro-rata share of the aggregate foreign cash position of CFC1 and CFC2 is USD $400 on the Cash Measurement Dates. USP’s aggregate foreign cash position for its 2017 taxable year (in which CFC1’s Mandatory Inclusion is taken into account) is USD $400 and its aggregate foreign cash position for its 2018 taxable year (in which CFC2’s Mandatory Inclusion is taken into account) is also USD $400. Therefore, the aggregate foreign cash position is double counted.
The IRS Notice 2018-07 provides that the IRS intends to issue regulations to address the double counting issue noted above. The regulation will provide that the U.S. Shareholder’s aggregate foreign cash position in any succeeding tax year will be its aggregate foreign cash position reduced by the amount of its aggregate foreign cash position taken into account in any preceding tax year. Applying this rule, the aggregate foreign cash position in 2018 will be $400 reduced by the amount of its aggregate foreign cash position taken into account in 2017.
The cash positions of non-corporate foreign entities should also be included if an SFC owns an interest in the non-corporate entity, and the entity would be considered an SFC if the entity is treated as a foreign corporation. 12
If a fiscal-year SFC anticipates that its aggregate cash position at the end of its fiscal year beginning before January 1, 2018 will be materially higher than the two-year average of the aggregate cash positions ending before November 2, 2018, the SFC may limit the aggregate cash position to the two-year average by making cash distributions before the end of its fiscal year to lower the balance sheet cash position to the two-year average subject to the anti-abuse provisions pursuant to Section 965(c)(3)(F).
v. Accumulated Post-1986 Deferred Foreign Income
The Mandatory Inclusion amount is the greater of an SFC’s post-1986 accumulated earnings and profits (“E&P”) measured as of November 2, 2017, or December 31, 2017 (the “Measurement Dates”). The accumulated E&P only includes the E&P of the foreign corporation during the period it was considered an SFC and excludes effectively connected income (“ECI”) and previously taxed income (“PTI”). Section 965 does not provide an exclusion for earnings accumulated while the U.S. Shareholder was not a direct, nor an indirect, owner of the SFC. Therefore, even if the U.S. Shareholder did not own any shares during a period when the foreign corporation was a classified as an SFC, he would need to include the deferred foreign income attributable to this period.
The extent to which an item of income, deduction, gain or loss is taken into account on the Measurement Dates should be determined under principles applicable to the calculation of E&P, including the application of Sections 312 and 964. Generally, E&P is reduced for distributions made during the year. However, for the purpose of computing the Mandatory Inclusion, an SFC’s post-1986 accumulated E&P is not reduced for distributions of dividends made during the tax year that includes the Measurement Dates.
E&P is the measure of a corporation’s ability to pay dividends to its shareholders. E&P is not the same as taxable income or book income. A proper computation of an SFC’s E&P is critical for the tax year of the Mandatory Inclusion.
The Treasury recognizes that it may be impractical for taxpayers to determine the post-1986 accumulated E&P of an SFC as of a Measurement Date that does not fall on the last day of the month. Therefore, the Treasury and the IRS intend to issue regulations providing that an election may be made to determine an SFC’s post-1986 accumulated E&P as of a Measurement Date based on the amount of post-1986 accumulated E&P as of another date (the “Alternative Method”). 13 Under the Alternative Method, the amount of the post-1986 accumulated E&P as of November 2, 2017, will equal the sum of (1) the SFC’s post-1986 accumulated E&P measured as of October 31, 2017, and (2) the SFC’s annualized E&P amount. The annualized E&P amount is a product of two multiplied by the daily earnings amount of the SFC. The daily earnings amount is the amount earned by the SFC through October 31, 2017 during the taxable year divided by the number of days in the tax year that includes October 31, 2017. 14
The annual computation of a foreign corporation’s E&P starts with the preparation of local P&L. Accounting adjustments are made to conform the local GAAP to U.S. GAAP. For example, funding may be classified as debt on the local P&L but as equity under U.S. GAAP. Further E&P adjustments are made to conform the U.S. GAAP earnings to certain U.S. tax accounting standards.
Common differences between U.S. GAAP retained earnings and E&P include the following:
- Following a purchase of a foreign corporation, U.S. GAAP retained earnings may have been adjusted for purchase price accounting. If the acquirer did not make a Section 338(g) election, the E&P is inherited as part of the acquisition for U.S. tax purposes.
- If a Section 338(g) election was made on the acquisition of the foreign corporation, the amortization allowed under Section 197 will create differences between U.S. GAAP and tax.
- Tax-free reorganizations and liquidations under the tax rules may create differences between U.S. GAAP and tax. For example, if a subsidiary checks the box to be liquidated into the parent, tax provisions transfer the subsidiary’s E&P (and assets) to the parent. Under U.S. GAAP, the subsidiary E&P may remain in the subsidiary.
- Amounts treated as a dividend may be different between U.S. GAAP and E&P.
- Foreign deferred compensation expense may not be deducted until it is paid to the beneficiary.
- Goodwill impairments may not reduce E&P if they would not otherwise be deductible.
- Purchase accounting for book purposes does not necessarily result in the same treatment for E&P.
Common differences between U.S. tax and E&P include the following:
- Meals and entertainment expenses may be fully deducted for E&P purposes.
- E&P depreciation must be determined under the alternative depreciation system (“ADS”).
- Fines and penalties are allowed as an E&P deduction.
- Payment of federal income taxes also reduce E&P.
- Tax-exempt income is included in E&P.
If a U.S. Shareholder owns at least one deferred foreign income corporation and at least one E&P deficit foreign corporation, the U.S. Shareholder can reduce its pro-rate share of the deferred income by its pro-rata share of the aggregate foreign E&P deficit. E&P deficit foreign corporation means, with respect to a taxpayer, if, as of November 2, 2017, (i) such specified foreign corporation has a deficit in post-1986 E&P, (ii) such foreign corporation was an SFC, and (iii) the taxpayer was a U.S. Shareholder of such corporation. 15
Hovering deficits may also be taken into account for this purpose. Under the hovering deficit rules, a target’s acquired E&P in an asset reorganization or a tax-free liquidation cannot be used to offset pre-acquisition positive E&P of the acquiring corporation. 16 Under the transition rules, the hovering deficit is not limited.
A U.S. Shareholder first computes its aggregate foreign E&P deficit which is the sum of its pro-rata share of the post-1986 E&P deficit of each of its SFC with deficits. The aggregate foreign E&P deficit is then allocated to the SFC’s with positive post-1986 E&P based on the relative amount of deferred income. The allocated deficit is treated as PTI under section 959. The E&P of the SFC that contributes its E&P deficit is increased by the amount of the contribution.
In the case of any affiliated group that includes at least one E&P net surplus shareholder and one E&P net deficit shareholder, the amount which would be taken into account as a Mandatory Inclusion by each E&P surplus shareholder is reduced by the shareholder’s applicable share of the affiliated group’s aggregate unused E&P deficit. 17
The above summary is not exhaustive and further analysis is warranted in light of the new legislation. U.S. Shareholders should review the accuracy of the accumulated foreign E&P that is reported on Form 5471. U.S. Shareholders should also review prior year transactions and elections made under Section 338(g) that may have impacted the SFC’s overall accumulated E&P position. In addition, U.S. Shareholders should validate their PTI pools that will lower their share of the Mandatory Inclusion. Newly issued IRS Notice 2018-13 provides guidance on section 965 and should be consulted.
vi. Planning Opportunities
A foreign corporation is not required to adopt an accounting method until its E&P becomes significant from a U.S. tax perspective. 18 Generally, a foreign corporation’s E&P becomes significant in the tax year of an actual or deemed distribution from the foreign corporation to its U.S Shareholder. The foreign corporation’s E&P is also significant in the year a U.S. Shareholder sells or exchanges the foreign corporation’s stock. The year of the Mandatory Inclusion is going to be a year when an SFC’s E&P becomes significant for all U.S. Shareholders.
A taxpayer is not required to elect or adopt a method of accounting for purposes of computing the E&P of a foreign corporation until the due date (including extensions) of the federal income tax return for the U.S. Shareholder’s first tax year in which the computation of its E&P becomes significant for U.S. federal income tax purposes. 19
If an SFC has not already adopted an accounting method for the tax year beginning before December 31, 2017, it may consider adopting appropriate accounting methods, or elections which may reduce its deferred foreign income. This may involve methods that may accelerate deductions or defer revenues to a period after the effective date of the Transition Tax. For a domestic corporation that is considered a U.S. Shareholder, any E&P attributable to a period after the effective date of the participation exemption system can be permanently sheltered from U.S. tax unless the income is currently includible under another provision of the Code. 20 Thus, future implications should be part of the analysis.
If a method is already adopted, the foreign corporation may change the accounting method with the permission of the Secretary. In order to implement a method change, each controlling domestic shareholder is required to file a statement with his tax return setting forth information required to be disclosed pursuant to Treas. Reg. Section 1.964-1(c)(3)(ii). For a controlling domestic shareholder that is the sole shareholder of the CFC, no separate statement needs to be filed if the information required to be disclosed under the regulation is included on Forms 5471, 3115, or 1128, as applicable. Before changing or adopting any accounting method, such strategy has to take into account the anti-avoidance provisions incorporated in the bill.
vii. Utilization of Tax Attributes
a. Foreign Tax Credits
The Mandatory Inclusion will bring up deemed paid foreign income tax credits (the “DPCs”). The DPCs are income taxes paid by foreign corporations that are deemed to be paid by the domestic corporations receiving actual or deemed dividends from the foreign corporations. In order to qualify for the DPC, the domestic corporation is required to own, directly or indirectly, 10% or more of the voting stock of a foreign corporation from which it receives dividends. Individuals and S corporations do not fall under these provisions.
The amount of the DPCs that attach to the Mandatory Inclusion will be based on the amount of the SFC’s foreign tax pool multiplied the amount of the Mandatory Inclusion over the post-1986 accumulated E&P of the SFC. 21
Foreign tax credits (“FTCs”), which include direct foreign taxes paid on the distribution (i.e., withholding tax), and the DPCs, described above, are disallowed to the extent they are attributable to the portion of the Mandatory Inclusion excluded from taxable income pursuant to the participation exemption. FTC carryforwards attributable to prior year transactions can be utilized in the tax year to offset the Transition Tax.
If the domestic corporation chooses to have the benefits of the DPC, then the amount of the DPC is treated as a dividend to the domestic corporation pursuant to Section 78 (“Section 78 Gross Up). 22 The U.S. Shareholder’s Section 78 Gross Up is equal to the DPCs attributable to the U.S. Shareholder’s taxable portion of the Mandatory Inclusion.
Domestic Corporation wholly owns an SFC with total deferred earnings of 200. 100 of the deferred earnings is attributable to the aggregate cash position, and the other 100 is attributable to the non-cash position. The SFC has a FTC pool of 70 on the E&P.
Domestic Corporation will be allowed a deduction of 55.71% on the cash portion, and 77.14% on the non-cash portion. The net taxable income after the deduction will be taxed at a 35% domestic corporate rate.
|Aggregate Cash Position||Non-Cash Position|
|Mandatory Inclusion (A)||100||100|
|Participation Exemption (B)||55.71%||77.14%|
|Amount Allowed as a Deduction (C) = (A) x (B)||(55.71)||(77.14)|
|Mandatory Inclusion less Participation Exemption (D) = (A)-(C)||44.29||22.86|
Section 78 Gross Up (E)
Foreign Tax Pool x Mandatory Inclusion/Accumulated E & P x Taxable Portion/Mandatory Inclusion
|Taxable Income (D)+(E)||90.65|
|Total U.S. Tax Liability at 35% before FTC (F)||31.73|
|Total Tax Payable (F)-(E)||8.23|
If a U.S. Shareholder plans on using the FTCs to offset its tax liability, it should also analyze the FTC limitation under Section 904. Generally, the amount of FTCs used in a tax year cannot exceed the U.S. tax imposed on the U.S. Shareholder’s foreign source income during the tax year. The limitation is computed separately for the two categories of income – passive category income, and general category income.
Generally, if a U.S. Shareholder generated foreign losses that offset U.S. source income in a prior year, such foreign losses are tracked and recaptured in a year that the U.S. Shareholder has overall foreign sourced income (the “OFL Account”). The rules re-classify a portion of the foreign sourced income as domestic source income. The maximum potential recapture is the lesser of the OFL Account balance, or 50% of the taxpayer’s total foreign taxable income. The statute does not address the Mandatory Inclusion on the U.S. Shareholder’s OFL position.
b. Electing Out of NOL Use
Section 965 also provides that a U.S. Shareholder may elect out of using net operating losses (“NOLs”) to offset the Mandatory Inclusion from the transition rules. This would allow a U.S. Shareholder to preserve some of the foreign source income to utilize the FTCs. Unused NOLs can be preserved to offset future domestic income.
viii. Payment Terms
A U.S. Shareholder may elect to pay the Transition Tax liability over an eight-year period. 8% of the taxes will be paid in each of the first five years, 15% in the sixth year, 20% in the seventh year, and 25% in the eighth year. The payment of the tax can be accelerated upon the occurrence of certain triggering events. Triggering events include the failure to timely pay any installments due, the sale of substantially all of the assets of the U.S. Shareholder, or the cessation of the taxpayer’s business.
Under the statute, REITs are allowed to distribute foreign income over an eight-year period using the installment percentages above to electing U.S. Shareholders.
ix. Special Provisions for S Corporations
S corporation shareholders may elect to defer paying the net tax liability until the occurrence of certain triggering events. Triggering events include a sale of S corporation shares, liquidation, sale of substantially all of the S corporation’s assets, termination of the S corporation status including a conversion to a C corporation, or a termination of the S corporation’s business. Upon the occurrence of a triggering event, the S corporation Shareholder may elect to pay its liability over an eight-year period. However, if the triggering event is the transfer of substantially all of the assets, liquidation, or the termination of the S corporation’s business, then the election is only available with the consent of the Secretary.
The amount of the Mandatory Inclusion should be treated as PTI for future tax years. Therefore, an S corporation should be able to receive actual distributions of earnings subject to the Transition Tax notwithstanding the deferral of such payments.
x. Future Distribution of Amounts Taxed Under these Rules
The Mandatory Inclusion treated as subpart F income will increase the pool of previously taxed earnings and profits (“PTI”). Dividend distributions from the PTI pool are not taxed when it is actually distributed. The PTI pool is a shareholder level tax attribute. 23
Similar PTI treatment applies to distributions between CFCs. An upper-tier CFC that receives a distribution of PTI from a lower-tier CFC is not required to include the distribution in income.
xi. Foreign Translation Impact
CFCs maintain their E&P pools in their functional currencies. 24 Section 989 requires the actual or deemed dividends to be translated when recognized. Generally, subpart F income is translated at the weighted average exchange rate for the taxable year. For the purpose of translating the Mandatory Inclusion, IRS Notice 2018-13 provides that the Treasury and the IRS intend to issue regulations providing that the appropriate exchange rate for translating the Mandatory Inclusion will be the spot rate on December 31, 2017. A distribution of PTI is translated at the spot rate on the date of the distribution.
The translated amount of the Mandatory Inclusion using the spot rate on December 31, 2017 may be different than the translated amount of the actual distribution received by a U.S. Shareholder as PTI. In the case of an actual distribution of E&P, the appropriate exchange rate is the spot rate on the date such distribution is included into income. 25
A U.S. Shareholder must recognize a foreign exchange gain or loss on the distribution of PTI by comparing the U.S.-translated Mandatory Inclusion and the U.S.-translated amount of the PTI distribution. Any gain or loss recognized is treated as ordinary income or loss from the same source as the original income inclusion.
If a U.S. Shareholder expects that the SFC’s foreign currency may depreciate in value, it should consider whether it would be appropriate to accelerate actual distribution of the SFC’s earnings.
xii. Anti-Inversion Provisions (for Ten Years After Effective Date)
If a U.S. Shareholder becomes an expatriated entity at any point during a ten-year period following the effective date of Section 965, the U.S. Shareholder will be denied the participation exemption and the Mandatory Inclusion amount will be taxed at a 35% rate. Additionally, no FTCs will be allowed to offset the additional tax liability imposed by the recapture rules.
xiii. Section 962 Elections for Individuals
The indirect deemed paid FTC (“DPC”) under Sections 902 and 960 is only available to a domestic corporations. Individuals, partnerships, or S corporations cannot claim a DPC for the foreign income taxes paid by the CFC. 26
An individual taxpayer may claim a DPC by electing to be taxed at the corporate income tax rates on subpart F income (the “Section 962 Election”). The Section 962 Election is only valid for the individual making the election and is binding for the tax year of the election. 27
An individual U.S. shareholder should consider whether a Section 962 Election may be appropriate for the year of the Mandatory Inclusion. An election is advantageous if the individual U.S. Shareholder is taxed at a higher effective tax rate than the highest corporate income tax rate during the inclusion year. Further, by making a Section 962 election, an individual U.S. Shareholder will find some relief from the effects of the Transition Tax because he would be able to claim a DPC. However, a substantial portion of the Mandatory Inclusion may again be subject to tax upon an actual distribution of such earnings because an individual’s PTI account is limited to the actual amount of tax paid.
An individual U.S. Shareholder should analyze whether making a Section 962 Election is appropriate.
xiv. State and Local Taxation
A U.S. Shareholder subject to the Transition Tax should also consider the state and local tax implications. The federal income tax mechanics of the Transition Tax which may affect state taxation are as follows:
- Mandatory Inclusion amount -- taxed as subpart F income:
a. Generally, states start their income tax computation from the federal taxable income. Some states exclude subpart F income from their taxable base. Certain states may adopt specific rules to account for the Transition Tax;
2. Deduction to gross income as a participation exemption:
a. Some state may require an add-back of special deductions including the participation exemption deduction against the Mandatory Inclusion;
3. Tax liability that may be paid over an eight-year period
a. The Transition Tax is recognized in the tax year containing the effective date even if the accrued tax liability may be paid out in installments over eight years. Unless there are specific legislative exceptions implemented by the different states, the state and local income taxes accrued on the Mandatory Inclusion amount should be recognized and paid in the effective tax year of the Transition Tax.
The treatment of the Transition Tax will likely vary by state, and each U.S. Shareholder impacted under these rules should analyze the potential state and local tax impacts.
1 Unless otherwise indicated, all Section references are to the Code.
2 Section 957
3 Prop. Reg. Section 1.898-1(c).
5 Sections 951(b), 957(c), 7701(a)(30) and 958(b).
6 The revised rule that changes the definition of a U.S. shareholder to include any U.S. person that owns at least 10% of vote or value will be effective for tax years beginning after December 31, 2017, and therefore, will not apply to the transition tax.
7 Section 7701(a)(30).
8 Section 965(e)(2).
9 A deduction of 55.7% is allowed to offset the Mandatory Inclusion for a calendar year taxpayer. The taxable portion is 44.3% of the Mandatory Inclusion.
10 Net accounts receivable is computed by taking the SFC’s excess of the accounts receivable balance over the accounts payable balance. Accounts receivable means receivables described in Section 1221(a)(4), and the term accounts payable means payable arising from the purchase of property described in Section 1221(a)(1), or 1221(a)(8) or the receipt of services from vendors or suppliers.
11 IRS Notice 2018-13.
12 Section 965(c)(3)(E).
13 IRS Notice 2018-13.
15 Section 965(b)(3)(B).
16 Section 381(c)(2).
17 Section 965(b)(5)(A).
18 Treas. Reg. 1.964-1(c)(6).
19 Treas. Reg. 1.964-1(c)(6).
20 The income should not be characterized as subpart F income, GILTI income, or investment in U.S. property, among others.
21 Section 960 and regulations thereunder.
22 Section 78.
23 Section 959.
24 Section 986(c).
25 Section 989.
26 Foreign taxes paid directly by individuals, partnerships, or S corporations may be claimed as a direct foreign tax credit pursuant to Section 901.
27 Treas. Reg. 1.962-2(c)(1)
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