Treasury and the IRS released a package of proposed regulations (REG-104226-18
) on Aug. 2 under Sections 965, 962 and 986(c). The package offers limited relief for taxpayers, and largely adopts guidance issued in previous notices. Although the proposed regulations do not meaningfully change the overall landscape of the Section 965 repatriation tax, the guidance provides comprehensive rules as well as examples covering numerous issues related to this one-time transition tax.
The proposed regulations are the first issued under Section 965, and are the latest development in the government’s ongoing series of releases on the subject since the signing of P.L. 115-97 (commonly referred to as the Tax Cuts and Jobs Act) on Dec. 22, 2017. The IRS previously released Notice 2018-26
, Notice 2018-07
, Notice 2018-13
, Revenue Procedure 2018-17
and a questions and answers document
posted on the IRS website. For previous Grant Thornton coverage of Notice 2018-26 click here
, Notice 2018-07 click here
, for coverage on Notice 2018-13 click here
, for coverage on Revenue Procedure 2018-17 click here
and for coverage on the questions and answers document click here
A substantial portion of the package adopts rules announced in prior notices. However, the proposed regulations do include some welcome new guidance and clarifications previously absent. The major sections of the package are highlighted below:
- Prop. Treas. Reg. Sec. 1.965-1 provides an overview, general rules and definitions, including Section 965(a) inclusion amounts, Section 965(c) deduction, among others.
- Prop. Treas. Reg. Sec. 1.965-2 provides rules on adjustments to E&P and stock basis.
- Prop. Treas. Reg. Sec. 1.965-3 provides specific rules for determining Section 965(c) deductions, and its treatment under various related Code sections.
- Prop. Treas. Reg. Sec. 1.965-4 provides rules that disregard certain transactions for Section 965 purposes. For example, the section contains anti-abuse rules disregarding changes in methods of accounting and entity classification elections undertaken to avoid the Section 965 tax.
- Prop. Treas. Reg. Secs. 1.965-5 and 1.965-6 provide rules on foreign tax credits.
- Prop. Treas. Reg. Sec. 1.965-7 provides rules for elections and payments.
- Prop. Treas. Reg. Sec. 1.965-8 provides the rules that apply to affiliated groups, including consolidated groups.
- Prop. Treas. Reg. Sec. 1.965-9 provides applicability dates.
- Regulations were also issued under Section 962, which allow individuals to elect to be taxed at corporate rates; and Section 986(c), which addresses previously taxed E&P under Section 965.
In general, 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 to be recognized as 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 (SFC). Specified foreign corporations are defined to include all controlled foreign corporations (CFCs) and all other foreign corporations (that 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 certain dividends paid during the taxable year.
Consolidated tax return and affiliated group rules
The proposed regulations provide additional guidance beyond what was previously described in Notice 2018-07 regarding the treatment of U.S. corporations that are members of a consolidated or an affiliated group. Consistent with the notice, all members of a consolidated group that are U.S. shareholders of an SFC are treated as a single U.S. shareholder for certain purposes of Section 965. This single shareholder treatment applies to:
- The allocation of deficits (under Section 965(b) and Prop. Treas. Regs. 1.965-1(b) (2))
- Installment payments and net operating loss elections (Sections 965 (h) and (o))
- The extension of the statute of limitations to six years (Section 965(k))
Single taxpayer treatment does not apply for 1) the purposes of determining any member’s income inclusion under Section 951 (including Section 965(a)), 2) any deduction under Section 965(c), and 3) deemed-paid foreign taxes under Section 960, which are computed on a separate member basis.
For purposes of determining a member’s Section 965(c) deduction, the member’s cash position is determined by reference to its pro rata share of the group’s total cash position. When determining the pro rata share, the member of a consolidated group has a portion of the total cash position equal to the aggregate Section 965(a) inclusion amount of the U.S. shareholder multiplied by the group cash ratio of the consolidated group.
The proposed regulations also provide additional guidance pertaining to the allocations of unused E&P deficits among affiliated group members not filing a consolidated tax return.
Previously taxed income rules
Current rules generally provide that income previously subject to U.S. federal income tax (for example, under Section 965) is excluded from the shareholder’s income if subsequently distributed in order to avoid double taxation.
The proposed regulations provide for two new types of previously taxed income. One type is created for an amount equal to the Section 965(a) inclusion amount (referred to as “section 965(a) previously taxed earnings and profits”). A second type is created for an amount equal to the amount of the reduction in the inclusion from an allocation of an E&P deficit (referred to as “Section 965(b) previously taxed earnings and profits”). These new types of previously taxed income provide the operative definition used in several other areas of the regulations, including rules for determining foreign income taxes paid or accrued, and rules related to foreign currency gain or loss. For example:
Specified foreign corporation basis adjustments
- Foreign currency gain or loss under Section 986(c) with respect to distributions of Section 965(a) previously taxed E&P is determined based on movements in the exchange rate between Dec. 31, 2017, and the date on which the E&P is distributed.
- Foreign currency gain or loss under Section 986(c) with respect to distributions of Section 965(b) previously taxed earnings and profits are not applicable because such amounts were not included in income under Section 951(a)(1).
The proposed regulations provide that under Section 961(a), a U.S. shareholder’s tax basis in a DFIC is increased by the Section 965(a) income inclusion amount. Generally, they indicate that no basis adjustments are made to account for the reduction to the Section 965(a) inclusion due to allocations of deficits of under Section 965(b) to a DFIC. However, pursuant to the proposed regulations, an election is available that allows the tax basis to be increased in the DFIC if a corresponding reduction of the tax basis of the E&P deficit corporation is made. Adjustments as a result of this election must be consistently made for all specified foreign corporations owned by the electing U.S. shareholder and related persons.
Grant Thornton Insight: Absent an affirmative action by the taxpayer, no basis adjustments will be allowed. As a result, taxpayers should carefully consider the election and potential benefits, if any.
This election generally must be made on a timely filed return (including extensions). However, the regulations provide transition rules that allow for additional time when the due date of the timely filed return occurs before the date that is 30 days after the date of publication in the Federal Register.
A domestic pass-through entity is defined to mean a partnership, S corporation, or certain other person to the extent that the income or deductions of such person are included in the income of its owners or beneficiaries. The proposed regulations make it clear that where a domestic pass-through entity is a U.S. shareholder of a DFIC and is subject to Section 965, then each domestic pass-through entity owner takes into account its share of the Section 965(a) income inclusion and the related Section 965(c) deduction, regardless if the owner is a U.S. shareholder. The proposed regulations also indicate that both the Sections 965(a) and (c) amounts must be allocated in the same proportion to pass-through owners.
In the case of a domestic partnership or S corporation, the proposed regulations provide that the aggregate amount of its Section 965(a) inclusions (net of the Section 965(c) deduction) is treated as a separately stated item for purposes of calculating basis under Sections 705 and 1367. The Section 965(c) deduction is also treated as tax-exempt income for purposes of tax basis and accumulated adjustment accounts of S corporations, thereby increasing the tax basis of the owners by the full amount of the Section 965(a) income inclusion. This tax basis adjustment is intended to adjust a shareholder’s basis such that a gain is not recognized upon actual distribution of cash.
Additional guidance on anti-abuse rules
The proposed regulations followed, with some modifications, the anti-avoidance rules contained in Section 3.04 of Notice 2018-26. The most significant modification was changing the condition required for the application of the principal purpose anti-abuse rule. The condition under Notice 2018-26 was a “change in Section 965 tax liability.” This condition was changed under the proposed regulations to a “change in the amount of a Section 965 element.” A change in a Section 965 element generally includes:
- a reduction in a Section 965(a) inclusion
- a reduction in the aggregate foreign cash position
- an increase in deemed-paid foreign income taxes.
Following guidance in Notice 2018-26, the proposed regulations also provide anti-abuse rules that disregard a change in an accounting method, or an election to change an entity’s classification if it changes a Section 965 element of a U.S. shareholder. Accounting method changes will only be impacted to the extent that a Section 965 element is changed. In other words, unfavorable method changes will not be impacted by the rule, and will be regarded when computing amounts under Section 965.
Foreign tax credit
Under Section 965(g)(1), no foreign tax credit is permitted for the applicable percentage of “taxes paid or accrued” or “treated as paid and accrued” with respect to any amount for which a Section 965(c) deduction is allowed. The proposed regulations clarify the meaning of “taxes paid or accrued” as foreign income taxes paid or accrued directly by the taxpayer under Section 901. The proposed regulations also clarify the meaning of “taxes treated as paid and accrued” as foreign income taxes deemed paid by the taxpayer under Section 960, foreign income taxes allocated to an entity under Treas. Reg. Sec. 1.901-2(f)(4) and a distributive share of taxes paid by a partnership.
The proposed regulations also clarify that the term “applicable percentage” is determined with respect to a Section 958(a) U.S. shareholder and a Section 958(a) U.S. shareholder inclusion year. For taxpayers with more than one Section 958(a) shareholder inclusion year, this may result in more than one applicable percentage. Multiple applicable percentages may also occur in situations where a person is a domestic pass-through owner with respect to more than one domestic pass-through entity.
TCJA repealed Section 902 effective for taxable years of foreign corporations beginning after Dec. 31, 2017, and taxable years of U.S. shareholders in which the tax years of those foreign corporations end. Included in the proposed regulations are rules that synchronize the provisions of Section 965 with the foreign tax credit provisions in effect before their repeal, in limited factual situations.
The proposed regulations also provide other clarifications and confirming changings related to foreign tax credit rules, including that:
- Sections 902 and 960 apply in the same manner for Section 965(a) inclusions as for other inclusions under Section 951(a)(1)(a).
- The numerator of the Section 902 fraction may be greater than the denominator as a result of the 965(a) inclusion amount being determined on one of two measurement dates.
Providing that if this occurs, the Section 902 fraction may not exceed one.
Acceleration of election to pay liability in installments
Section 965(h) provides that if a taxpayer makes an election under Section 965(h), the net tax lability may be paid in eight installments. Section 965(h)(3) provides a list of events (including, for example, if there is an addition to tax for failure to timely pay an installment) that accelerates the unpaid portion of the remaining installments, making them due on the date of such event.
The proposed regulations provide some relief in this area. If a person is assessed a deficiency, then 1) timely files a return increasing the amount of net tax liability above the amount taken into account in the payment of the first installment, or 2) files an amended return increasing the amount, then the deficiency or additional amount will be prorated among the future installments. Thus, if a taxpayer makes an installment election and does not pay the correct amount for the first installment, the remaining installment payments will generally not be accelerated, and the taxpayer’s election will not be affected.
Grant Thornton Insight: In a memorandum issued Aug. 2, the IRS Office of Chief Counsel provided the Large Business and International division with legal authority on Answer 14 of the Q&As. Q&A 14 addresses the issue of whether taxpayers that made an election under Section 965(h) could obtain a refund of any amount paid that was in excess of their Section 965 net tax liability. The IRS stated that it would not issue any refunds unless the amounts paid were in excess of the entire 2017 income tax liability, including all amounts to be paid installments over the next seven years.
The Chief Counsel’s office concluded in the memorandum that an overpayment of tax occurs when payments exceed the amounts that are properly due. The amount properly due for the 2017 tax year was the taxpayer’s entire income tax liability as well as the Section 965 liability, which was eligible to be paid in installments. In the case of a tax payable in installments, Section 6403 provides that any amounts paid in excess of the correct amount of the installment is to be applied to any unpaid installments.
Taxpayers that made additional payments and have sought refunds through Forms 4466, “Corporation Application for Quick Refund of Overpayment of Estimated Tax,” are unlikely to see such refunds paid to the extent they are made for excess payments of their Section 965 liability.
S corporation triggering events
Section 965(i) provides that a shareholder of an S corporation that is itself a U.S. shareholder may elect to defer payment of its net tax liability under Section 965 with respect to such S corporation until the shareholder's taxable year which includes a so called “triggering event” with respect to such liability.
Under the proposed regulations, an event will not be treated as a triggering event if it is the transfer of any share of stock of the S corporation by the shareholder and an eligible transferee enter into a transfer agreement. The proposed regulations also provide rules for an S corporation shareholder to obtain the consent of the IRS to make a Section 965(h) election for certain triggering events.
Other items of significance
A few other notable items addressed in the preamble to the proposed regulations are highlighted below:
- Despite multiple comments requesting guidance to be issued addressing the repeal of Section 958(b)(4) (the so called “downward” attribution rules), the issue is described as “beyond the scope of the proposed regulations.”
- The preamble discusses a number of issues impacting individuals that were the focus of numerous comment letters. For example, individuals subject to the transition tax at higher effective rates as a result of the deduction under Section 965(c) calculated based on the corporate tax rate, and Section 1411 tax being ineligible for the installment election. The proposed regulations adopt no changes related to these comments.
- The package contains rules addressing the application of Section 962, which are generally consistent with guidance in Notice 2018-26. For example, the proposed regulations contain rules providing individual domestic pass-through owners that are U.S. shareholders with respect to a DFIC the ability to make an election under Section 962.
- Treasury also addressed comments requesting a simplified method of measuring post-1986 earnings for specified foreign corporations that are not CFCs. Treasury and IRS acknowledged the burden placed on taxpayers to obtain accurate information, however points out that the challenge is not unique and numerous longstanding provisions require the computation of E&P.
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 proposed regulations are generally effective beginning for the last taxable year of a foreign corporation that begins before Jan. 1, 2018 (and with respect to U.S. persons, the taxable years in which or with which such taxable years of the foreign corporations ends).
The proposed regulations address some unanswered questions relating to Section 965, but largely followed previous guidance and legislative history. Taxpayers subject to Section 965 should nonetheless closely review the guidance. Although a number of the provisions are referred to as “clarifications,” prior to this guidance some of these rules may have been interpreted differently by different taxpayers. This could impact previous estimates, including provisional amounts recorded in financial statements.
Several unanswered questions remain related to hovering deficits: certain aspects of the interplay between foreign tax credit limitations, expense apportionment and Section 965, and rules relating to distributions out of previously taxed income, among other things. The IRS is continuing to accept and review comments on all aspects of the proposed regulations, and there may be further (or refined) guidance addressing Section 965 in the coming months. However, with the 60-day comment period, this guidance should not be expected prior to the due date of tax returns for 2017 calendar year taxpayers.
For more information contact:
Washington National Tax Office
+1 202 861 4104
Washington National Tax Office
+1 202 521 1543
Washington National Tax Office
+1 202 521 1509
Mike Del Medico
Washington National Tax Office
+1 202 521 1522
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