Proposed Regulations on Section 965 Released
September 13, 2018
By Harold Adrion and Chip Niculae
On August 1, 2018, the IRS released proposed regulations (the “Proposed Regulations”) under Section 965 of the Internal Revenue Code (the “Code”), which generally requires a “U.S. shareholder” (which for this purpose generally includes U.S. corporations, partnerships, trusts, estates, and individuals who own 10% of a foreign corporation’s voting power) to pay a “transition tax” on the earnings of a deferred foreign income corporation (“DFIC”)* as if such earnings had been repatriated to the U.S.
For domestic corporations, foreign earnings held in the form of cash and cash equivalents are generally intended to be taxed at a 15.5% rate and the remaining earnings are intended to be taxed at an 8% rate.
The lower effective tax rates applicable to Section 965 income inclusions are achieved by way of a participation deduction set out in Section 965(c) of the Code.
Section 965(a) provides that, for the last tax year of a DFIC beginning before January 1, 2018 (the inclusion year), the subpart F income of the corporation shall be increased by the greater of: (1) the accumulated post-1986 deferred foreign income of such corporation determined as of November 2, 2017, or (2) the accumulated post-1986 deferred foreign income of such corporation determined as of December 31, 2017 (the measurement dates). For purposes of Section 965, a DFIC is any SFC of a U.S. shareholder that has accumulated post-1986 deferred foreign income (as of a measurement date) greater than zero.
Taxpayers may generally elect to pay the transition tax in installments over an eight-year period under Section 965(h) of the Code. The Proposed Regulations contain detailed information on the calculation and reporting of a U.S. shareholder’s Section 965(a) inclusion amount, as well as information for making the elections available to taxpayers under Section 965.
Highlights of Proposed Regulations
The Proposed Regulations with some modifications follow several notices, “frequently asked questions,” and a revenue procedure on Section 965. The IRS previously released Notice 2018-26, Notice 2018-13, Revenue Procedure 2018-17 and a question-and-answer document posted on the IRS website.
The Notices provided that certain transitions and accounting method changes would be disregarded. The Proposed Regulations adopt the position of the notices; however, they limit the disregard of transactions, accounting method changes and entity classification elections solely for purposes of Section 965.
Section 965(g)(1) and (3), respectively, disallow a credit under Section 901 and deduction for the applicable percentage of any foreign income “taxes paid or accrued (or treated as paid or accrued)” with respect to any amount for which a section 965(c) deduction is allowed.
Application to Affiliated Corporations
The Proposed Regulations provide that U.S. shareholders are treated as a single U.S. shareholder for certain purposes of Section 965. This single shareholder treatment applies to a) the allocation of deficits (under Section 965(b); b) installment payments and net operating loss elections; and c) the extension of the statute of limitations to six years.
Single taxpayer treatment does not apply for a) the purpose of determining any member’s income inclusion under Section 951(including Section 965(a)); b) any deduction under Section 965(c); and
c) deemed-paid foreign taxes under Section 960, which are computed on a separate member basis.
Application of Section 965 to Individuals and Partnerships
The Proposed Regulations provide that if a domestic pass-through entity is a U.S. shareholder of a DFIC and is subject to Section 965, then each domestic pass-through entity owner takes into account its share of the Section 965(a) income inclusion and the related Section 965(c) deduction, regardless if the owner is a U.S. shareholder.
Section 962 provides an election (“Section 962 election”) for a U.S. individual shareholder of a controlled foreign corporation (“CFC”) to be taxed on the subpart F income inclusion of the CFC at the corporate rate of tax. Prop. Reg. Section 1.962-2(a) confirms that a U.S. individual (including a trust or estate) who owns a DFIC through a domestic pass-through entity (e.g., a domestic partnership) may make the Section 962 election but only if the U.S. individual is a U.S. shareholder of the DFIC.
U.S. individuals who own a less-than 10% interest in a U.S. pass-through entity can be subject to the Section 965 inclusion and not get the benefit of Section 962. For example, if a U.S. individual owns a 1% interest in a U.S. partnership and the U.S. partnership is considered a U.S. shareholder in a DFIC, the individual will include its share of the 965 inclusion but will be unable to use the Section 962 election because it is not a U.S. shareholder.
The Proposed Regulations provide that, for individuals, estates, and trusts subject to both the Section 965 and the Section 1411 net investment income tax of 3.8%, the Section 1411 tax is levied against the Section 965(a) inclusion amount without reduction for the Section 965(c) participation exemption. Such tax may, however, be deferred until the earnings subject to Section 965 are distributed to the taxpayer.
Application of Section 965 to S Corporations
The Proposed Regulations seem in line with prior guidance provided for S corporations by the Treasury Department and IRS. In addition, the Proposed Regulations expand on guidance provided by previous notices with respect to Sections 965(f), 965(h) and 965(i). According to Section 965(f)(2), the portion that should be included in a U.S. shareholder’s income under Section 951(a)(1) due to Section 965(a) that is equal to the Section 965(c) deduction amount should be treated as income exempt from tax for purposes of Section 1367(a)(1)(A). However, the income is not exempt from tax for purposes of determining whether an adjustment should be made to an accumulated adjustment account of an S corporation under Section 1368(e)(1)(A).
Proposed Regulation 1.965-2 clarifies the basis adjustment rules with respect to Section 965(a) and 965(b) that are applicable to foreign stock owned by S corporations and other domestic pass-through entities. For example, in instances where an S corporation holds an indirect interest in a DFIC through a series of lower tier foreign companies, a Section 965(a) inclusion increases the stock basis of the foreign entities in the ownership chain by the amount of the inclusion. Moreover, an adjustment resulting from the 965 inclusion to an S corporation’s basis in a domestic flow-through entity should be calculated in accordance with Subchapter S, not the Proposed Regulations. Furthermore, the abovementioned inclusions should also result in an adjustment in the S corporation’s accumulated adjustment account.
Under Proposed Regulation 1.965-3(f)(1), a Section 965(c) deduction may not be treated as an itemized deduction. Moreover, Proposed Regulation 1.965-3(f)(2) provides that an S corporation’s net aggregate Section 965(a) inclusion amount should be treated as a separately stated item of net income for the purposes of calculating basis under Section 1367(a)(1) and Proposed Regulation 1.1367-1(f).
Section 965(i) permits a shareholder of an S corporation that in turn owns shares in a DFIC to elect to defer payment of the shareholder’s net tax liability under Section 965 with respect to the S corporation until the shareholder’s taxable year that includes the triggering event with respect to such liability. Under Proposed Regulation 1.965-7(c)(3), a shareholder of an S corporation may elect an eight-year installment method after a triggering event. However, in order to benefit from this new proposed exception, the shareholder must obtain the consent of the IRS Commissioner before making the eight-year installment election. Section 965(h) grants a U.S. shareholder of a DFIC the option of electing to pay the Section 965 net tax liability in eight installments. According to the Proposed Regulations, an eight-year installment election is made at the level of the shareholder and not by the S corporation or other pass-through entities.
In addition, a shareholder of an S corporation may also enter into an agreement with the IRS Commissioner for the deferral of the Section 965(i) net tax liability triggered by the transfer of the S corporation’s stock to an eligible transferee. The shareholder must file the agreement with the Commissioner within 30 days of the transaction characterized as a triggering event.
* A DFIC is a specified foreign corporation (“SFC”) that had a deferred amount on either November 2, 2017 or December 31, 2017. An SFC is a non-U.S. corporation that either (a) is a CFC or (b) has at least one U.S. shareholder that is a U.S. corporation and is itself neither a CFC nor a passive foreign investment company described in Section 1297