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IRS releases additional guidance on Section 965 transition tax

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The IRS released additional guidance (Notice 2018-26) on April 2 covering the transition tax under Section 965 enacted by the Tax Cuts and Jobs Act (TCJA). The guidance includes:

  • Limited penalty relief for estimated tax payments
  • Limited relief from the new controlled foreign corporation (CFC) attributions rules
  • Guidance for stock sales and foreign taxes paid between measurement dates
  • Rules curbing transactions, entity classifications, and accounting method changes to reduce earnings and profits (E&P)

Notice 2018-26 is just the latest release in a string of releases on Section 965, following Notice 2018-07 (Grant Thornton coverage), Notice 2018-13 (Grant Thornton coverage), Revenue Procedure 2018-17 (Grant Thornton coverage) and a questions and answers document posted on the IRS website (Grant Thornton Coverage).

Background In general, newly amended Section 965 imposes a transition tax on previously untaxed post-1986 foreign E&P of certain foreign corporations owned by a U.S. shareholder. Section 965 deems those earnings to be repatriated, resulting 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 (SFCs), which are defined to include all 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. E&P is measured as the greater amount on 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.

Relief for determination of SFC The notice indicates that the IRS intends to issue regulations providing that, solely for purposes of determining whether a foreign corporation is an SFC, certain stock owned, directly or indirectly, by a partner in a partnership will not be considered as being constructively owned by the partnership if such partner owns less than 5% of the interests in the partnership’s capital and profits. This welcome relief comes in response to the repeal of Section 958(b)(4) under the TCJA. The repeal allowed the downward attribution rules of Section 318 to apply, resulting in certain foreign corporations being characterized as SFCs as a result of the constructive ownership rules provided in Section 958(b). Citing compliance difficulties for taxpayers and administrative difficulties for the IRS, the notice provides relief from the application of those rules in these limited circumstances involving partners in partnerships.

Cash measurement dates The notice provides guidance on determining the appropriate cash measurement dates in certain situations where an SFC may not be owned by a particular U.S. shareholder on the cash measurement dates described in Section 965(c)(3)(A).

The cash measurement dates in Section 965 are defined to be:

  • The close of the last taxable year that begins before Jan. 1, 2018,
  • The close of the last taxable year which ends before Nov. 2, 2017, and
  • The close of the last taxable year which precedes the last taxable year which ends before Nov. 2, 2017

The IRS recognized that taxpayers need guidance for situations where the SFC goes out of existence, stock is acquired, or stock is sold between measurement dates. The notice indicates that the IRS intends to issue regulations providing that:

  • The final cash measurement date of a SFC is the close of the last taxable year of the SFC that begins before Jan. 1, 2018, and ends on or after Nov. 2, 2017.
  • The second cash measurement date of a SFC that end is the close of the last taxable year that ends after Nov. 1, 2016, and before Nov. 2, 2017.
  • The first cash measurement date of a SFC is the close of the last taxable year that ends after Nov. 1, 2015, and before Nov. 1, 2016.

Furthermore, the IRS intends to issue regulations specifying that a U.S. shareholder must take into account its pro rata share of the cash position of an SFC as of any cash measurement date on which it is a U.S. shareholder, regardless of whether the shareholder holds stock on other measurement dates.

Foreign income taxes accruing between measurement dates Notice 2018-13 previously clarified that, for purposes of measuring the post-1986 E&P of an SFC on a particular measurement date, the general rules applicable to the calculation of E&P, including the application of Sections 312 and 964, applied to SFCs for purposes of Section 965. Notice 2018-13 also provided a limited exception to the general rules for computing E&P that allowed for an annualized approach when computing the Nov. 2, 2017, E&P amount.

However, several unanswered questions remained regarding the calculation of E&P as of that measurement date. For example, it was unclear whether expenses, which were not fixed and determinable until year-end (such as foreign taxes) would be allowed to reduce the Nov. 2, 2017, E&P measurement. It appeared that absent an exception to the general rules, foreign taxes accruing after Nov. 2 would generally not be allowed as a deduction when computing the E&P as of that measurement date.

Notice 2018-26 addressed this issue by providing an additional limited exception to the general rules for certain foreign income taxes that accrue between measurement dates (i.e., after Nov. 2, 2017, but on or before Dec. 31, 2017). The exception provides that for purposes of determining an SFC’s post-1986 earnings and profits as of the measurement date on Nov. 2, 2017, any foreign income tax that accrues between the measurement dates will be allocated between the respective portions of the foreign tax base on which the accrued foreign taxes are determined.

This limited exception was provided only for foreign taxes, and it is not available for other deductions, which may not be fixed and determinable until after Nov. 2, 2017 (e.g., certain bonus not paid until after Dec. 31, 2017). The limited exception is also only relevant for purposes of determining an SFC’s post-1986 E&P (including a deficit) under Section 965(d)(3) and will not affect the computation of credits for taxes deemed paid under Sections 902 and 960.

Transactions reducing E&P Importantly, the IRS stated in the notice that the government intends to issue regulations providing that certain transactions will be disregarded for purposes of determining a U.S. shareholder’s Section 965 liability pursuant to an anti-avoidance rule.

Specifically, the anti-avoidance rule will apply and transactions will be disregarded if each of the following conditions is satisfied:

  • The transaction occurs, in whole or part, on or after Nov. 2, 2017.
  • The transaction is undertaken with a principal purpose of reducing such U.S. shareholder’s Section 965 liability.
  • The transaction would otherwise reduce the Section 965 liability of such U.S. shareholder.

Under the notice, certain transactions are presumed to be undertaken with a principal purpose of reducing the Section 965 liability. The presumption can be rebutted by a taxpayer but only if facts and circumstances clearly establish that the transaction was not undertaken with a principal purpose of reducing the Section 965 liability. A rebuttal will require that a taxpayer attach a statement to the return disclosing that is has rebutted the presumption.

The notice provides three categories of transactions that are presumed to be undertaken with a principal purpose of reducing a U.S. shareholder’s Section 965 liability:

  • Cash reduction transactions
  • E&P reduction transactions
  • Pro-rata share transactions

In the case of cash reduction and E&P reduction transactions, the notice specifically provides that the presumption rule does not apply to transactions occurring in the ordinary course of business. Finally, each category of transaction contains certain described transactions that are “per se” considered as being undertaken with the principal purpose of reducing the Section 965 liability.

Cash reduction transactions
A “cash reduction transaction” is defined as a transfer of cash, accounts receivable, or cash equivalent assets by an SFC to (1) a U.S. shareholder of the SFC or to a person related to a U.S. shareholder of the SFC, or (2) an assumption by an SFC of an accounts payable of a U.S. shareholder of the SFC, or (3) a person related to a U.S. shareholder of the SFC if the transaction reduces the aggregate foreign cash position of the U.S. shareholder.

For purposes of these provisions, a “transfer” includes any disposition, exchange, contribution, distribution, issuance, redemption, recapitalization, or loan -- and includes an indirect transfer. A special rule provides that a distribution that is not a “specified distribution” by an SFC to a U.S. shareholder will per se not be considered as undertaken with a principal purpose of reducing the Section 965 liability. The term-specified distribution means a distribution where (1) at the time of the distribution there was a plan or intention to transfer directly or indirectly certain assets to any SFC of the U.S. shareholder; or (2) the distribution is a non-pro rata distribution to a foreign person related to the U.S. shareholder.

E&P reduction transaction
An “E&P reduction transaction” is one that is undertaken by an SFC that results in a reduction in the accumulated post-1986 deferred foreign income or the post-1986 undistributed earnings of that SFC, with the exception of a transaction occurring in the ordinary course of business. The notice also provides that a “specified transaction” will be treated as per se undertaken with a principal purpose of reducing the Section 965 liability. The term specified transaction includes an E&P reduction transaction that involves one or more of the following:

  • Complete liquidation to which Section 331 applies
  • Sale or other disposition of stock by an SFC
  • Distribution by an SFC that reduces E&P of the SFC pursuant to Section 312(a)(3)

Pro rata share transaction
A “pro rata share transaction” is defined as the transfer of stock of an SFC to a U.S. shareholder or related person if such a transfer would do any of the following:

  • Reduce the Section 965 earnings amount of the SFC if it is a deferred foreign-income corporation (DFIC)
  • Increase the shareholders’ pro rata share of the specified E&P deficit of an E&P deficit corporation
  • Reduce the shareholders’ pro rata share of the cash position of the SFC

The notice also provides that certain “internal group restructurings” will be per se treated as undertaken with a principal purpose of reducing the Section 965 liability.

Accounting method changes and entity classifications reducing E&P Section 965(o) granted the IRS broad authority to prevent avoidance of the Section 965 transition tax, including through a reduction in E&P by changes in entity classifications or accounting methods. In the notice, the IRS created a per se rule that disregards any change in method of accounting for purposes of Section 965 if the change was not filed before Nov. 2, 2017, and otherwise reduced the taxpayer’s Section 965 tax liability. Notably, the per se rule applies irrespective of whether or not such change in method of accounting was made in accordance with the normal procedures described in Rev. Proc. 2015- 13, and whether such change in the method of accounting was properly made.

As a result, taxpayers may be required to use otherwise impermissible methods of accounting when computing E&P for the purposes of Section 965 if changing to a permissible method of accounting would result in a lower Section 965 tax lability. However, it appears method changes that result in an increase to the Section 965 tax liability are unaffected by the per se rule. Ostensibly, it appears even if the net result of several method changes produced an overall increase in the Section 965 tax liability, the favorable method changes would be disregarded under the per se rule because they would, in isolation, reduce the Section 965 tax liability.

The notice also provides a similar per se rule for entity classification election under Treas. Reg. Sec. 301.7701-3. Under this per se rule, any entity classification election filed on or after Nov. 2, 2017, will be disregarded for purposes of Section 965 if such election would otherwise reduce the taxpayer’s Section 965 tax liability. Similar to the per se rule above for accounting methods changes, entity classifications that increase the Section 965 tax liability appear to still have an effect for the purposes of computing the Section 965 E&P.

Both per se rules apply regardless of whether such a change in the method of accounting or a change of entity classification election is made with a principal purpose of reducing the Section 965 tax liability of a taxpayer.

Elections, reporting and payment The notice clarified a number of areas related to elections, reporting and payment of tax. Specifically, the IRS intends to issue guidance on the documentation of certain cash position matters, provide relief for the timing of tax payments for certain taxpayers residing abroad, and identify how the net tax liability under Section 965(h) is determined for certain owners for pass-through entities.

Most notably, guidance is provided with respect to the treatment of “current year losses” and the election of Section 965(n) to forgo the use of net operating losses (NOLs) in determining the Section 965 amount. The regulations will provide that if an election under Section 965(n) is made, the amount of a NOL for the year will be treated as made with respect to both the amount of an NOL for that taxable year and for the NOL carry-overs and carry-backs in the same taxable year.

Also of note, the notice clarifies the treatment of certain items related to pass-through entities, pass-through owners and eligibility for elections. The notice makes it clear that if the pass-through entity is a U.S. shareholder of a deferred foreign income corporation (DFIC), that the Sections 965 (a) and (c) income inclusions and deductions are determined at the pass-through entity level. Regulations will state that each pass-through entity owner takes into account its share of the Sections 965 (a) and (c) income inclusions and deductions, regardless of whether the pass-through owner is a U.S. shareholder. Both the Sections 965 (a) and (c) amounts must be allocated in the same proportion. If the pass-through owner is also a U.S. shareholder in a DFIC, regulations will be issued to provide that the owner and pass-through income inclusions and deductions are determined separately.

The IRS also intends to issue regulations related to the following elections:

  • Section 965(h): Installment payment of the net tax liability
  • Section 965(m): Real estate investment trust elections
  • Section 965(n): Forgoing the use of NOLs against Section 965 income

The elections apply to all Section 965(a) income inclusions regardless if income is earned through a pass-through entity or directly. The notice also indicates that the government intends to issue regulations permitting shareholders of S corporations, who are U.S. shareholders of a DFIC and also pass-through entity owners, to make a Section 965(i) election.

Section 965(c) deduction for individuals The notice provides that an individual’s Section 965(c) deduction is not an itemized deduction subject to the 2% floor, as some taxpayers had feared.

Modification of definitions of accounts receivable and payable in Notice 2018-13 The IRS previously issued guidance under Notice 2018-13 providing that the term “accounts receivable” means receivables described in Section 1221(a)(4) and also that the term “accounts payable” means payables arising from the purchase of property described in Sections 1221(a)(1) or 1221(a)(8). Notice 2018-26 modifies this guidance by excluding any receivable or payable with an initial term of one year or more for purposes of calculating a specified foreign corporation’s net accounts receivable. The modification narrows the assets and liabilities considered when computing a specified foreign corporation’s net accounts receivable.

Elections under Section 962 The regulations will clarify that a domestic entity pass-through owner who is an individual and a U.S. shareholder with respect to a DFIC may make an election under Section 962 related to the Section 965(a) income inclusion from a pass-through entity related to that DFIC. Individuals who are not U.S. shareholders of a DFIC are not permitted to make the election under Section 962 with respect to this DFIC.

The notice makes it clear that, if Section 962 is elected, the tax imposed on Section 965 income inclusion is the corporate rate under Section 11 and that this computation does not include any other deductions. The notice also indicates that the IRS intends to issue regulations indicating that the Section 965(c) deduction would be allowed based on Section 11 and used in the computation of the Section 962 tax. The deduction would not be allowed for purposes of individual taxable income. The tax computed under Section 962 is separate from the individual tax computations on other income.

Penalty relief The IRS will waive any estimated tax underpayment penalties under Sections 6654 and 6655 for both individual and corporate taxpayers related to the Section 965 tax. This waiver of tax applies to taxpayers that make a Section 965(h) election as well as for those that do not. As a result, a taxpayer’s required installments of estimated tax do not need to include the amounts attributable to net tax liability under Section 965.

However, if a taxpayer fails to timely pay its net tax liability under Section 965 when it is due, other additions to tax may occur, including the penalty under Section 6651 for a failure to pay, as well as an acceleration of Section 965 installment payments under Section 965(h)(3).

Finally, the notice also waives estimated tax underpayment penalties related to the amendments of Sections 965 or 958(b) by the tax reform law that resulted in an underpayment of estimated tax due on or before Jan. 15, 2018.

Effective dates 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 regulations and instructions described in the notice will generally become effective beginning for the first taxable year of a foreign corporation (and with respect to U.S. shareholders, the taxable years in which or with which such taxable years of the foreign corporations end) to which Section 965 applies. Before the issuance of regulations, taxpayers may rely on the rules described in the notice.

Next steps The notice addresses many previously unanswered questions related to Section 965. Taxpayers subject to Section 965 should closely review the guidance. The notice and guidance released by the IRS provide significant clarity to previously ambiguous portions of Section 965, but many uncertainties remain in application and interpretation.

The IRS is continuing to accept and review comments on issues associated with Section 965, and there will likely be further guidance in the coming months. In the interim, taxpayers should continue assessing the impact of Section 965 and the notice on their operations, and consider alerting either the IRS or their tax advisor of any issues encountered that are not addressed in the recent guidance.

For more information contact: David Sites
Partner, International Tax
Washington National Tax Office, Grant Thornton LLP
T +1 202 861 4104

David Zaiken
Managing Director, International Tax
Washington National Tax Office, Grant Thornton LLP
T +1 202 521 1543

Cory Perry
Senior Manager, International Tax
Washington National Tax Office, Grant Thornton LLP
T +1 202 521 1509

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