Previously Taxed Income Nuances Post-TCJA
February 24, 2020
By Matthew Halpern
There are several nuances that you should be aware of when preparing and reviewing your tax returns in a post-Tax Cuts and Jobs Act (“TCJA”) world.
The TCJA had created a one-time repatriation, or what many call “transition,” tax under Section 965 of the Internal Revenue Code (“§965”) as it relates to the accumulated profits in any specified foreign corporation (“SFC”). This forced U.S. shareholders of an SFC to include their share of the untaxed accumulated profits as income and establish a §965 previously taxed earnings and profits (“PTEP”) account. Under a PTEP account, future SFC distributions would not be taxable again to the extent they do not exceed the §965 PTEP account.
However, due to an inclusion-of-income event in 2017, or fiscal year SFC in 2018, and a distribution of cash in a later year, there may be a realized §988 currency gain or loss. This foreign currency transaction is treated as additional ordinary income or loss in the year of the actual cash distribution. You must compare the distribution, converted to U.S. dollars on the date paid, with the amount of income included on the tax return, also in U.S. dollars, and previously taxed with the prior inclusion event.
After a §965 inclusion event, distributions from that same SFC will first come out of the §965 PTEP accounts prior to reducing your other §959(c)(1) PTEP or other §959(c)(2) accounts. This is a departure from the regular ordering rules on PTEP distributions, because the IRS is looking to utilize these previously taxed earnings before moving onto the new Global Intangible Low-Taxed Income (“GILTI”) provisions.
Withholding Taxes on an SFC Distribution
In the event that a withholding tax has been applied on a cash distribution from an SFC to a U.S. shareholder, it generally is treated as a dividend for the local country purposes, hence the withholdings, but not for U.S. purposes. From a U.S. perspective, you had previously established a PTEP account for the deemed income inclusion. You must identify the specific PTEP account that was previously established (i.e., §965, §951A, §951A or §956) for the actual cash distribution.
Under §960, a U.S. shareholder can generally utilize the withholding taxes as a foreign tax credit in the year of receipt, and this credit will be attributable to the same category of income previously recognized. However, to the extent that the U.S. shareholder received a deduction on the income previously recognized, and to which this distribution is attributable, the same inclusion percentage would be applied to reduce the foreign withholding taxes available for credit.
Example: Under §965, U.S. shareholders received a 55% deduction on their inclusion of E&P. The previous inclusion was $45,000 ($100,000 * 1-.55 = $45,000). If the SFC now distributes $100,000 and has a $15,000 withholding tax, only $6,750 would be creditable ($15,000 * 1-.55 = $6,750). The remaining withholding taxes are disallowed and never creditable.
The same would apply to a distribution attributable to a GILTI inclusion, to the extent that a U.S. shareholder received a 10% qualified business asset investment deduction or utilized the tested loss of another SFC on the overall income inclusion.
The shareholder will also have to establish an excess limitation account to increase or decrease their §904 foreign tax credit limitation. This ensures that the taxpayer does not take a foreign tax credit in excess of the actual withholding taxes applicable to the income previously recognized.
Net Investment Income Tax
Under §1.1411-10, a current inclusion of income under §951 or §951A is not subject to the net investment income tax (“NIIT”), unless a §1.1411-10(g) election is in place. A 10(g) election allows a U.S. shareholder to include the §951 or §951A inclusion when there is a deemed inclusion, as opposed to when actually distributed. If no election is in effect, the NIIT would not apply until an actual cash distribution has been made. These distributions would now be from PTEP accounts established previously and, therefore, should not be treated as current dividend income for purposes of computing your regular tax liability, but they are treated as a dividend for purposes of the NIIT. This requires adjustments to the investment income and modified adjusted gross income calculations on Form 8960.
You should review the prior tax return in which the foreign income inclusion occurred to verify that the deemed inclusion was not subject to the NIIT, unless a 10(g) election was in place.