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Tax reform: IRS clarifies repatriation transition tax, other international aspects

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Signing a tax formOn Jan. 19, the IRS and Treasury issued Notice 2018-13, which provides guidance for computing the transition tax and guidance in connection with the repeal of Section 958(b)(4) under the new tax reform bill enacted on Dec. 22 (commonly referred to as the Tax Cuts and Jobs Act).

The notice is the second notice released addressing the transition tax since the signing of the Tax Cuts and Jobs Act. On Dec. 29, the IRS and Treasury issued Notice 2018-07, which also provided guidance for computing aspects of the transition tax under the Tax Cuts and Jobs Act. For previous Grant Thornton coverage of Notice 2017-07 click here.

In addition to bringing welcome clarity to areas of the transition tax, the notice provides relief from certain unintended consequences of a change to the attribution rule due to the repeal of Section 958(b)(4). But for this exception, the repeal would have resulted in many foreign-owned U.S. corporations being subject to significantly increased Form 5471 reporting. The notice provides an exception to Form 5471 reporting when a foreign corporation is deemed to be owned by a U.S. person exclusively through constructive ownership from a non-U.S. person.

Background In general, newly amended Section 965 imposes a transition tax on previously untaxed post-1986 foreign earnings and profits (E&P) of certain foreign corporations owned by a U.S. shareholder. Section 965 deems those earnings to be repatriated and results in an income inclusion for the U.S. shareholder of the foreign corporation. Foreign earnings considered held in the form of cash and cash equivalents are taxed at a 15.5% rate, and the remaining earnings are taxed at an 8% rate.

The transition tax is applicable to U.S. shareholders in “specified foreign corporations.” Specified foreign corporations are defined to include all controlled foreign corporations (CFCs) and all other foreign corporations (which are not passive foreign investment corporations) with at least one U.S. corporation that is a U.S. shareholder.

The transition tax is imposed by using the Subpart F rules to require applicable U.S. shareholders to include their pro rata share of post-1986 E&P in income to the extent such E&P has not been previously subject to U.S. tax. The E&P is measured as the greater amount at either Nov. 2, 2017, or Dec. 31, 2017. The inclusion in income is for the foreign subsidiary’s last taxable year beginning before 2018, and is determined without regard to any dividends paid during the taxable year.

The Tax Cuts and Jobs Act also amended the ownership rules of Section 958(b)(4). Generally, Section 958(b) provides rules for determining stock ownership for purposes of the definition of a U.S. shareholder under Section 951(b), the definition of a related person included in the foreign base company sales income rules under Section 954(d)(3), various reasons under Section 956(c)(2), and the definition of a CFC under Section 957.

Prior to repeal, Section 958(b)(4) prohibited “downward” attribution of stock ownership from a foreign person to a U.S. person. However, the Tax Cuts and Jobs Act repealed Section 958(b)(4) such that stock owned (directly, indirectly or constructively) by a foreign person will be attributed downward to U.S. persons in certain situations. The provision is effective on a retroactive basis beginning with the last taxable year of foreign corporations beginning before Jan. 1, 2018, and all subsequent years of such foreign corporations, and for taxable years of U.S. shareholders in which, or with which, such taxable years of foreign corporations end.

The notice at a glance Determination of status as a ‘deferred foreign income corporation’ or an ‘E&P deficit foreign corporation’
For purposes of Section 965, a “deferred foreign-income corporation” (DFIC) is any specified foreign corporation of a U.S. shareholder that has accumulated post-1986 deferred foreign income (as of a measurement date) greater than zero. An “E&P deficit foreign corporation” is any specified foreign corporation of a U.S. shareholder that, as of Nov. 2, 2017, has a deficit in post-1986 E&P.

The notice indicates that the IRS intends to issue regulations providing that, for purposes of determining the status of a specified foreign corporation, it must first be determined whether the specified foreign corporation is a DFIC. If the specified foreign corporation meets the definition of a DFIC, it is classified solely as a DFIC and not also as an E&P deficit foreign corporation.

Interestingly, the notice provides an example where a specified foreign corporation may be classified as neither a DFIC nor an E&P deficit foreign corporation, despite having post-1986 E&P greater than zero or a deficit in accumulated post-1986 deferred foreign income. This anomaly can result when the specified foreign corporation has previously taxed income. Previously taxed income is excluded when determining DFIC status, but is included when determining E&P deficit foreign corporation status.

Alternative method for calculating post-1986 E&P
For purposes of determining whether a specified foreign corporation is a DFIC and for purposes of determining a DFIC’s Section 965(a) earnings amount, the actual post-1986 E&P of the specified foreign corporation must be determined as of the close of both Nov. 2, 2017, and Dec. 31, 2017. However, many taxpayers where finding it impractical to determine the post-1986 E&P of a specified foreign corporation as of a measurement date that does not fall on the last day of a month.

The IRS recognized the impracticability of a measurement date that does not align with a financial close and intends to issue regulations providing an election to determine a specified foreign corporation’s post-1986 E&P on an alternative method. If the alternative method is elected, the post-1986 E&P (and deficits, as applicable) as of Nov. 2, 2017, will equal the sum of the foreign corporation’s post-1986 E&P as of Oct. 31, 2017, and its annualized E&P amount. For this purpose, the term “annualized earnings and profits amount” means, with respect to a specified foreign corporation, the amount equal to the product of two (the number of days after October 31, 2017, and on or before the measurement date on November 2, 2017). The daily earnings is the post-1986 E&P (and deficits, as applicable) of the specified foreign corporation that were earned during the specified foreign corporations taxable year as of the close of Oct. 31, 2017 divided by the by the number of days that have elapsed in such taxable year as of the close of Oct. 31, 2017.

The notice also clarifies that, for purposes of measuring the post-1986 E&P of a specified foreign corporation as of a measurement date, the extent to which an item of income, deduction, gain or loss is taken into account as of such measurement date must generally be determined under principles applicable to the calculation of E&P, including the application of Sections 312 and 964.

Treatment of deficits
Prior to the notice, it was not clear how certain deficits of an E&P deficit foreign corporation should be allocated when the entity has multiple classes of stock outstanding. Section 965(f)(1) provides that rules similar to Section 951(a)(2) should be applied. However, such rules do not address deficits. The IRS intends to issue regulations providing that, for purposes of determining a U.S. shareholder’s pro rata share of the specified E&P deficit of an E&P deficit foreign corporation that has multiple classes of stock outstanding, the specified E&P deficit is allocated first among the shareholders of the corporation’s common stock and in proportion to the value of the common stock held by such shareholders.

The IRS also intends to issue regulations clarifying that all deficits related to post-1986 E&P, including hovering deficits, are taken into account for purposes of determining the post-1986 E&P (including a deficit) of a specified foreign corporation.

Determination of aggregate foreign cash position
The notice also provides two clarifications to the rules applicable when determining the cash position for the use of the 15.5% rate. The cash position of any specified foreign corporation is the sum of (i) cash held by such corporation, (ii) the net accounts receivable of such corporation, and (iii) the fair market value of certain liquid assets held by such corporation, including, among others, any obligation with a term of less than one year — also known as a short-term obligation.

The Code does not define the term “accounts receivable” for purposes of the term “net accounts receivable.” To clarify the provision, the IRS intends to issue regulations providing that the term “accounts receivable” means “receivables described in Section 1221(a)(4).” Section 1221(a)(4) describes receivables as accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of inventory property. The regulations will also provide that the term “accounts payable” means “payables arising from the purchase of property described in Sections 1221(a)(1) or 1221(a)(8)” (i.e., inventory or certain supplies) or the receipt of services from vendors or suppliers. Receivables that are treated as accounts receivable will not also be treated as short-term obligations. Finally, the notice provides that a demand loan (or loan that must be repaid within one year of a lenders demand) will be treated as a short-term obligation, regardless of the stated term of the instrument.

Translation Rules
The notice provides guidance in a number of areas related to the appropriate translation rates required when computing the inclusion and related attributes. The IRS intends to issue regulations providing, among other things, the following:

  • For purposes of determining the Section 965(a) inclusion amount of a specified foreign corporation, the accumulated post-1986 deferred foreign income as of each of the measurement dates (i.e. Nov. 2, 2017, or Dec. 31, 2017) must be compared in the functional currency of the specified foreign corporation.
  • The appropriate exchange rate under Section 989(b) for translating the Section 965(a) earnings amount is the spot rate on Dec. 31, 2017, regardless of a specified foreign corporation’s taxable year or the applicable measurement date.
  • For purposes of Section 986(c), foreign currency gain or loss with respect to distributions of previously taxed income described in Section 959(c)(2) by reason of Section 965 will be determined based on movements in the exchange rate between Dec. 31, 2017, and the date on which such previously taxed E&P are actually distributed.

The spot rate on Dec. 31, 2017, will apply for purposes of translating other amounts necessary for the application of Section 965(b), including:

  • Translating a Section 965(a) earnings amount into U.S. dollars in computing the allocation of aggregate foreign E&P deficits
  • Translating a specified E&P deficit into U.S. dollars in order to determine a U.S. shareholder’s aggregate foreign E&P deficit
  • Translating a Section 965(a) inclusion amount with respect to a DFIC for purposes of determining the previously taxed income of the DFIC.
  • Translating the portion of the U.S. dollar-denominated aggregate foreign E&P deficit allocated to a DFIC into the functional currency of the DFIC for purposes of determining its previously taxed income under Section 965(b)(4)(A).

Finally, the IRS intends to issue regulations providing that the cash position of a specified foreign corporation must be expressed in U.S. dollars. Therefore, the amount of a U.S. shareholder’s aggregate foreign cash position will be the greater of the U.S. dollar-denominated aggregate amounts on each of the applicable cash measurement dates (as described in Section 965(c)(3)(A)).

Elimination of form 5471 filing obligation for certain constructive owners

The Tax Cuts and Jobs Act also amends the ownership rules of Section 958(b)(4) allowing downward attribution from non-U.S. persons. An unintended consequence of this change would have resulted in expanded compliance burdens for many U.S. subsidiaries of foreign-parented groups. In other words, a U.S. subsidiary in a foreign multinational group would have been, as a result of downward attribution, deemed to own its foreign parent’s interest in other foreign brother/sister entities for purposes of determining whether such foreign corporations are CFCs. But for an exception, this change would have required the controlled U.S. subsidiary of foreign-patented groups to file Forms 5471 reporting each of the foreign brother/sister entities that it was deemed to own.

To prevent this unintended consequence, the IRS intends to amend the instructions for Form 5471. The amended instructions would provide an exception from Category 5 filing for a U.S. person that is a U.S. shareholder with respect to a CFC if no U.S. shareholder (including such U.S. person) owns, within the meaning of Section. 958(a), stock in such CFC, and the foreign corporation is a CFC solely because such U.S. person is considered to own the stock of the CFC owned by a foreign person under Section 318(a)(3).

Other guidance
The notice provides various other guidance, including clarification of the application of the gain-reduction rule described in Notice 2018-07, and guidance relating to special rules for determining the source of certain items of gross income, including gross income from space and ocean activities and international communications income.

Effective/applicability date Section 965 is effective for the last taxable years of foreign corporations that begin before Jan. 1, 2018, and with respect to U.S. shareholders, for the taxable years in which or with which such taxable years of the foreign corporations end. The IRS intends for the regulations addressing Section 965 described in the notice to be effective for the period in which Section 965 applies. Until regulations are issued, taxpayers may rely on the rules described in the notice.

The repeal of Section 958(b)(4) is effective for the last taxable year of foreign corporations beginning before Jan. 1, 2018, and each subsequent year of such foreign corporations and for the taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end. Until the change to Form 5471 instructions addressing the constructive ownership exception is made, taxpayers may rely on the exception described in the notice for the period in which the repeal of Section 958(b)(4) is effective.

Next steps The new notice provides welcome guidance in the wake of enacted tax reform changes brought about by the Tax Cuts and Jobs Act. However, many unanswered questions remain. Taxpayers should carefully analyze the notices and the new statute to determine the impact on their organizations. As noted, the new law and related notices apply retroactively to the 2017 tax year. The implications are likely to impact many taxpayers, both from a tax and generally accepted accounting principles perspective. Taxpayers should evaluate the notice to understand the tax and accounting implications for their businesses.

Contacts David Sites
Partner, International Tax Services
Washington National Tax Office
+1 202 861 4104

David Zaiken
Managing Director, International Tax Services
Washington National Tax Office
+1 202 521 1543

Cory Perry
Senior Manager, International Tax Services
Washington National Tax Office
+1 202 521 1509

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