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Beware of the Transition Tax as it Relates to Net Investment Income

On August 1, 2018, the IRS issued proposed regulations on the IRC Section 965 Transition Tax. In many cases, the regulations provided clarity and examples to various taxpayer situations as well as answers to many questions. As with most regulations, upon review of the details, taxpayers will find little nuances to look out for.

One of those nuances is regarding when the net investment income tax under Internal Revenue Code Sec. 1411 comes into play. An amount included in gross income under section 951(a) or 1293(a) [Subpart F income/965(a) income/qualified electing fund (“QEF”) income] is not treated as a dividend unless expressly provided for in the Code. The general rule is that the net investment income tax would apply when cash or other property is distributed from the controlled foreign corporation (“CFC”) or QEF to the extent of earnings and profits earned after December 31, 2012.  The amount which could have been previously included in gross income is thus taxable to the shareholder for net investment income tax purposes when a distribution is made.  Therefore, the timing of amounts taxable for purposes of gross income may be different than when the tax liability arises for net investment income tax purposes which is based on actual distributions under the general rule.

One of the exceptions to this is when a taxpayer makes a §1.1411-10(g) election. If such election has been made with respect to a CFC or QEF, amounts included in gross income for chapter 1 purposes under §951(a) or §1293(a) with respect to the CFC or QEF in taxable years beginning with the year of the election are treated as net investment income even if there has been no actual distribution.  Thus, making the election will result in the net investment income tax arising when there is a Subpart F inclusion.   The election, if made, will remain in effect for all later years and is irrevocable.

There is another exception to the general rule that net investment income tax arises when an actual distribution is made. If a taxpayer has a §951(a) inclusion attributable to specific types of income such as interest, dividends, annuities, royalties, or rents not generated in the ordinary course of a trade or business, the inclusion will be taxable under the net investment income tax provisions as well. Typically, these types of income would generate Subpart F income under §951(a) which is taxable income and the net investment income tax would arise when there is a Subpart F inclusion.

There is another nuance to take into consideration. A taxpayer is only subject to the net investment income tax when their modified adjusted gross income exceeds certain thresholds.

As a result of the above, income reportable as Subpart F under the transition tax may give rise to net investment income tax liability if the taxpayer had made the election in an earlier year to include Subpart F income as income for net investment income tax purposes or if the inclusion of gross income negatively affects the modified adjusted gross income computation.  

The rules are particularly onerous because the IRS has determined that the installment election under section 965(h) for payment of the regular transition tax is not available for net investment income tax.

Similar considerations arise in connection with the reporting of income post-2017 under the new rules involving GILTI (global intangible low taxed income) under §951A.

These rules are complex; taxpayers should consult their tax advisor to deal with the ramifications.

Matthew Halpern is a Tax Manager working in various industries such as professional services, information technology, and manufacturing and distribution. He also works with expatriates and foreign individuals with U.S. activity.

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