The Internal Revenue Service (IRS) and US Treasury Department have issued the first set of highly anticipated proposed regulations with respect to the international tax provisions of the Tax Cuts and Jobs Act (TCJA). They address Internal Revenue Code Section 965, otherwise known as the mandatory toll tax, transition tax or repatriation tax. They also follow on the release of several IRS Notices (Notice 2018-07, Notice 2018-13 and Notice 2018-26) which provided preliminary guidance with respect to several challenges affecting the application and operation of the transition tax rules.
For a refresher on the fundamentals of this transition tax, see our alert titled TAX REFORM: The International Provisions (Part 1)- Section 965 Deemed Repatriation Tax published on February 7, 2018.
The purpose of this alert is to make taxpayers aware of the new proposed regulations and highlight areas to pay close attention to, especially for purposes of any tax return reporting and compliance for the fall / winter tax filing deadlines.
Note the proposed regulations are divided into the following sections:
- Proposed Regulations Section 1.965-1: general rules and definitions
- Proposed Regulations Section 1.965-2: adjustment to E&P and basis
- Proposed Regulations Section 1.965-3: determination of section 965(c) deductions
- Proposed Regulations Section 1.965-4: disregarded transactions
- Proposed Regulations Section 1.965-5: foreign tax credits
- Proposed Regulations Section 1.965-6: foreign tax credits
- Proposed Regulations Section 1.965-7: elections and payments
- Proposed Regulations Section 1.965-8: affiliated/consolidated groups
- Proposed Regulations Section 1.965-9: dates of applicability
Proposed Regulations Section 1.965-1
These proposed regulations provide general rules and definitions with respect to Section 965(a) inclusion amounts, US shareholder status, controlled foreign corporation status, specified foreign corporation status, reductions to Section 965(a) earnings and inclusion amounts, cash measurements dates, cash equivalents, accounts receivables, domestic pass thru entities, etc.
A few interesting items to highlight here include the fact that a specified foreign corporation (SFC) includes a controlled foreign corporation as well as a 10% US-owned corporation (that is also not treated as a passive foreign investment company). The indirect and constructive attribution rules come into play in determining US shareholder status for purposes of ascertaining if an entity is a SFC (including partners of a partnership owning a potential SFC). For these purposes, the proposed regulations provide a special carve out exemption for tested partners in a partnership that arguably own an insignificant capital or profits interest in the partnership (i.e., less than 5%).
Also, for purposes of calculating earnings and profits of a deferred foreign income corporation (i.e., SFC with positive earnings and profits or DFIC), there are now special rules for reducing the earnings and inclusion amount of an impacted US shareholder for the period during which such US shareholder did not have US shareholder status in reference to their ownership in the entity (i.e., a period during which the US person owned less than 10%).
Guidance is provided with respect to adjustments for cash equivalent amounts, in particular, adjustments related to derivative financial instruments (excluding bona fide hedging activities).
Multi-tiered domestic partnership structures and determination of the reporting US shareholder for purposes of section 965 are also discussed.
Proposed Regulations Section 1.965-2
These proposed regulations contain prescriptive rules related to the calculation of earnings and profits as well as basis adjustments for purposes of determining the transition tax. Specifically, the regulations include a five step process for analyzing earnings and profits, taking into account any reductions for subpart F income and distributions governed by section 959.
Regarding basis, a US shareholder’s basis in an asset is generally increased for their share of subpart F income. Similarly, the regulations provide for a corresponding basis increase related to a US shareholder’s section 965(a) inclusion amount. However, the regulations are reserved on this basis increase as it relates to instances in which a US shareholder elects Section 962 status. See our accompanying article, IRS and Treasury Department Release Proposed Regulations Providing Transition Tax Guidance: Part 2 of 2.
Additionally, the proposed regulations prescribe limitations on gain recognition and special netting rules for specified basis adjustments.
Proposed Regulations Section 1.965-3
Section 965(c) provides for the participation deduction for a US shareholder of a DFIC. This participation deduction effectively reduces the section 965(a) inclusion amount of the US shareholder. These proposed regulations provide rules regarding the section 965(c) deduction including disregarded amounts to alleviate double counting, the recapture of certain deductions for expatriated entities and special rules for partnerships and S corporations with respect to treatment of their section 965(c) deduction amounts.
Proposed Regulations Section 1.965-4
These proposed regulations put forth rules that disregard certain transactions designed purposefully to avoid the transition tax (i.e., anti-tax avoidance rules). They include check-the-box elections and accounting method changes.
Proposed Regulations Section 1.965-5
These proposed regulations provide rules governing the allowance of a foreign tax credit or deduction in relation to the section 965 mandatory inclusion. The essence of the rule is that an applicable amount of foreign tax credit or deduction is allowed for that amount of the section 965 inclusion that is taxable in the US and that no foreign tax credit or deduction is allowed for the portion of the inclusion that is not taxable as a result of the section 965(c) participation exemption deduction. Amounts not allowable as a foreign tax credit by application of this rule are also not allowable as a deduction.
The proposed regulations provide an “applicable percentage” mechanism to disallow the portion of foreign tax allowable for credit or deduction to .771 for taxes attributable to the shareholder inclusion taxed at the 8% rate and .557 for credit or deduction for the shareholder inclusion taxed at the 15.5% rate.
There is also a coordination provision regarding deemed foreign income taxes paid which limits the deemed foreign tax to the proportion of the excess of the inclusion amount over the section 965(c) deduction amount..
Proposed Regulations Section 1.965-6
This section provides rules for the computation of foreign income taxes deemed paid and the allocation and apportionment of deductions.
For purposes of determining foreign taxes deemed paid with respect to the section 965 inclusion, section 902 applies to treat the inclusion translated at the spot rate into the functional currency (if necessary) on December 31, 2017 as a dividend. The section 902 fraction amount for this purpose is the inclusion amount over the foreign corporation’s post-1986 undistributed earnings and profits. Where the denominator of the fraction is less than the numerator, but more than zero, the fraction is one. When the denominator is zero the fraction is zero and no foreign taxes are deemed paid.
For purposes of allocation and apportioning expenses, a section 965(c) deduction does not result in any gross income, including a section 965(a) inclusion being treated as exempt, excluded or eliminated income within the meaning of section 864(e)(3) or 1.861-8T(d). Nor does a section 965(c) deduction result in the treatment of stock as an exempt asset within the meaning of those sections.
Proposed Regulations Section 1.965-7
These proposed regulations address the time and manner for making certain elections with respect to the transition tax. Summarily, they clarify each of the available elections, instructions for installment payments, accelerated payments, consolidated group reporting matters and what happens in the case of underpayments, misrepresentations and omissions.
Proposed Regulations Section 1.965-8
This section provides rules for applying section 965 and the section 965 regulations to members of an affiliated group, including members of a consolidated group. These include rules regarding the determination of section 965(a) inclusion amounts for members of an affiliated group, guidance for designating the source of aggregate unused earnings and profits deficits, rules regarding earnings and profits and stock basis adjustments, rules that treat members of a consolidated group as a single person for certain purposes, definitions that apply for purposes of this section and examples of how these rules should be applied.
These are fairly specific rules to be applied under the relevant facts of varying affiliated and consolidated group circumstances and not the subject for topical synopsis here.
Proposed Regulations Section 1.965-9
Proposed Regulations Sections 1.965.1 through 1.965-8 apply beginning with the last taxable year of a foreign corporation that begins before January 1, 2018, and with respect to a US person, beginning with the taxable year in which, or with which, such taxable year of the foreign corporation ends.
Proposed Regulations Section 1.965-4 (concerning disregard of certain transactions) applies regardless of whether, with respect to a foreign corporation, the transaction, effective date of a change in method of accounting, effective date of an entity classification election or specified payment under Proposed Regulation 1.965-4 occurred before the first day of the foreign corporations last taxable year that begins before January 1, 2018 or with respect to a US person those same matters occurred before the first day of the taxable year of the US person in which, or with which, the taxable year of the foreign corporation ends.
In summary, the 200+ pages of the section 965 proposed regulations have certainly clarified and enhanced many of the challenges faced by taxpayers and practitioners in computing the transition tax. However, there are still issues to resolve in terms of not only the calculation but also reporting and compliance. The proposed regulations are now subject to a 60 day public comment period. We will continue to monitor the development of these proposed regulations and will report accordingly.
Please contact your Mazars USA LLP professional for additional information.