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IRS and Treasury Department Release Proposed Regulations Providing Transition Tax Guidance: Part 2 of 2

August 3, 2018

By Richard Bloom, Tifphani White-King, Mark O'Loughlin and Mark Tadros

Background

The passage of the Tax Cuts and Jobs Act (TCJA) in December 2017 introduced the highly complex Internal Revenue Code (IRC) section 965, which imposes a “transition tax” on accumulated earnings & profits of certain foreign corporations.  As this was effective immediately for the 2017 tax year, many taxpayers and tax professionals were left with little time to prepare and adjust for the changes.   On the evening of Wednesday, August 1st the IRS released the highly anticipated proposed regulations with respect to section 965.  The 249 page release provided much needed guidance and clarity. This article will highlight how the proposed regulations impact IRC section 962 and 986.

US tax treaties generally state that a US individual may claim foreign tax credit relief for foreign individual income taxes imposed, while a domestic corporation may claim foreign tax credit relief for foreign corporate taxes imposed.  While the concept is simple – individual to individual and corporate to corporate, challenges are faced by US individual shareholders with respect to their deemed income inclusions from foreign corporations.  Namely, the recognition of income under code section 951(a), better known as Subpart F, would leave an individual in a position of being subject to tax on foreign sourced income with no associated foreign tax credits.  With the passage of the TCJA, IRC section 965 has increased the prominence of the scarcely used provisions of IRC section 962.

In general, under Section 965, US shareholders of a Specified Foreign Corporation (SFC) which is also a Deferred Foreign Income Corporation (DFIC) are subject to tax on their post-1986 untaxed earnings & profits (Post-1986 E&P).  The Post-1986 E&P is measured at November 2, 2017 or December 31, 2017, with the transition tax imposed on the higher of the two amounts.  A SFC is any Controlled Foreign Corporation (CFC) or any foreign corporation which has a 10% or more US shareholder, while a DFIC is any SFC that has untaxed Post-1986 E&P greater than zero.  The untaxed Post-1986 E&P held in cash & cash equivalents is taxed at 15.5%, with the remaining amounts taxed at 8%.

Section 965(a) states that any untaxed Post-1986 E&P will be deemed repatriated and taxed as Subpart F income under section 951(a), while section 965(c) provides a deduction in order to achieve the effective tax rates of 15.5% and 8%.

Code Section 962 provides that an individual who is a US shareholder may make an election to be taxed as a domestic corporation with respect to their gross income under section 951(a) for purposes of claiming the related foreign tax credits.  Seemingly, this would provide an individual with foreign tax credit relief from the new tax imposed under section 965.  However, section 962 further states that the taxable income determined for computing the corporate tax amount may not be reduced by any deduction of the US shareholder.  As the deduction under 965(c) is considered to be separate from 951(a), code section 962, as written, would not allow this deduction.

Additionally, there was ambiguity as to whether an individual could make a section 962 election with respect to their share of a 965(a) inclusion coming from a domestic pass-through entity, and whether their share of the section 965(c) deduction would be allowed in the computation of taxable income undersection 962.

Mazars Insight

When making a section 962 election, only the net tax paid will be considered previously taxed income.  Careful analysis should be done to consider if this election is the optimal position for the taxpayer.

Section 962 Proposed Regulations

The proposed regulations clarify that the taxable income determined when making a section 962 election will allow for the deduction as outlined in section 965(c), thus alleviating concerns that no code section or regulation specifically allowed for it.  Further, the proposed regulations clarify that an individual US shareholder of a DFIC through a domestic pass-through may make a section 962 election with respect to their share of the 965(a) inclusion of a DFIC, but a person who is a foreign shareholder cannot.

Taxable income under section 962 will be computed as:

  1. Section 965(a) inclusions and their share of 965(a) inclusions from domestic pass-throughs, PLUS
  2. Deemed foreign tax paid with respect to income included in part 1 (section 78 gross up), LESS
  3. Section 965(c) deductions and their share of 965(c) deduction amounts from domestic pass-throughs.

Without Election

962 Election – Before Proposed Regulations

962 Election – After Proposed Regulations

965(a) Inclusion

965(a) Inclusion

965(a) Inclusion

+

+

965(c) Deduction

Section 78 Gross-UP

Section 78 Gross-UP

 

965(c) Deduction

=

=

=

Amount included on Form 1040 Line 21, Other Income

Amount Subject to Corporate Tax Rates

Amount Subject to Corporate Tax Rates

Additionally the proposed regulations clarify that a 962 election may be made only by an individual (including a trust or estate) who is a US shareholder, specifically mentioning that this includes those who are US shareholders by reasons of indirect ownership through a domestic pass-through.

Mazars Insight

The wording of the proposed regulation on the computation of taxable income under section 962 creates confusion as to whether the deemed foreign tax paid amount  (IRC section 78) is reduced in the same proportion as the section 965(c) deduction, thus including only the amount of allowable deemed foreign tax paid in taxable income.  Based on the coordination with the section 78 rule in the proposed regulation 1.965-5(c)(3), we believe this is the case.

Section 986 Proposed Regulations

Income included under section 965(a) is considered to be previously taxed income (PTI).  Thus, a taxpayer is not subject to tax when the PTI amounts are actually distributed.  However, the distributions of cash will create a foreign currency gain or loss with respect to the PTI.  The proposed regulations clarify how foreign currency gains and losses should be computed under section 986 with respect to section 965.

The proposed regulations provide that a foreign currency gain or loss with respect to previously taxed 965(a) inclusions should be determined based on the currency exchange rate differences between December 31, 2017 and the date of any actual distribution.

Mazars Insight

This eliminates confusion for those subject to the transition tax with a measurement date of November 2nd.

In addition, any currency gain or loss recognized with respect to section 965(a) inclusions should be reduced in the same proportion as the section 965(c) deduction associated with the 965(a) inclusion that created the PTI. These rules apply only to distributions of PTI created as a result of section 965.  They do not apply to distributions related to other PTI.

Please contact your Mazars USA LLP professional for additional information.

 


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Mazars USA LLP is an independent member firm of Mazars Group.

Legal and privacy policy    Contact us    Terms and Conditions