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On March 13, 2018, the Internal Revenue Service (IRS) released “Questions and Answers about Reporting Related to Section 965 on 2017 Tax Returns.”1
This guidance primarily addresses the reporting and payment of tax resulting from the amendment of Internal Revenue Code (IRC) Sec. 965, relating to a one-time deemed repatriation that may result in additional taxable inclusions for many businesses (including C corporations, S corporations and pass-through entities).2
The IRC Sec. 965 taxable income is reportable for calendar-year taxpayers on the 2017 tax return and the tax generally is payable at the un-extended due date for such return. An election is also available for taxpayers to pay the tax in installments over an eight-year period. Further, S corporation shareholders may elect to indefinitely defer the payment of the tax subject to certain limitations. The state income tax consequences of the repatriation are extremely complex and uncertain, and the release of the IRS guidance may have made the analysis more difficult.
IRC Sec. 965 generally requires U.S. shareholders to pay a transition tax on the untaxed foreign earnings of certain specified foreign corporations. This one-time deemed repatriation occurs in the last taxable year of certain specified foreign corporations beginning before January 1, 2018, and the amount included in income under IRC Sec. 965 is includible in the U.S. shareholder’s year in which or with which such a specified foreign corporation’s year ends. As a result, affected calendar-year taxpayers may be required to pay tax resulting from IRC Sec. 965 by April 17, 2018.
There are two steps in the transition tax calculation under IRC Sec. 965. First, under IRC Sec. 965(a), Subpart F income is increased by unrepatriated earnings from foreign subsidiaries (i.e., a gross income inclusion).3
Second, under IRC Sec. 965(c), there is a “participation exemption” deduction, which provides a deduction that effectively reduces the tax rate on unrepatriated earnings to 15.5 percent on earnings attributable to cash and cash equivalents, and 8 percent on the remainder.4
Also, taxpayers may elect under IRC Sec. 965(h) to pay the tax liability in installments over eight years,5
and S corporation shareholders may elect under IRC Sec. 965(i) to defer the tax liability until the taxable year in which a triggering event (i.e., the S corporation terminates or the shareholder transfers the S corporation stock) occurs with respect to such liability.6
Federal Return Treatment
The IRS guidance requires all taxpayers that have income under IRC Sec. 965 for their 2017 taxable year to include with their return an “IRC 965 Transition Tax Statement.” This statement must provide the taxpayer’s total amount required to be included in income under IRC Sec. 965(a) and deduction under IRC Sec. 965(c); the total net tax liability under IRC Sec. 965; and a listing of elections under IRC Sec. 965 that the taxpayer has made. Furthermore, the guidance requires that the IRC Sec. 965 amounts be reported on a 2017 tax return in distinctive fashion, depending upon the type of taxpayer involved.
The IRC Sec. 965(a) addition is not reflected on Form 1120. Instead, this amount is included on IRC Sec. 965 Transition Tax Statement, Line 1.
The IRC Sec. 965(c) subtraction is not reflected on Form 1120, but this amount is included on IRC Sec. 965 Transition Tax Statement, Line 3.
The “net tax liability” calculated on the Transition Tax Statement (incorporating the IRC Sec. 965(a) addition and the IRC Sec. 965(c) subtraction, with other adjustments) is included on Form 1120, Schedule J, Line 11, which is reflected on Form 1120, Line 31 (total tax).
To the extent that a taxpayer defers the tax over eight years, the refundable credit entry on Form 1120, Schedule J, Line 19 is used to reflect amounts to be paid in tax years beyond 2017, which is reflected on Form 1120, Line 32 (total payments and refundable credits).
The IRC Sec. 965(a) addition is included on Form 1120S, Schedule K, Line 10 (other income). This amount would be reported by the S corporation owners based on their respective shares of the profits and losses in the S corporation.
The IRC Sec. 965(c) subtraction is included on Form 1120S, Schedule K, Line 12d (other deductions). This amount would be reported by the S corporation owners based on their respective shares of the profits and losses in the S corporation.
The IRC Sec. 965(a) addition is included on Form 1120S, Schedule K, Line 11 (other income). This amount would be reported by the partners on their own returns based on their respective shares of the profits and losses in the partnership.
The IRC Sec. 965(c) subtraction is included on Form 1120S, Schedule K, Line 13d (other deductions). This amount would be reported by the partners on their own returns based on their respective shares of the profits and losses in the partnership.
The IRC Sec. 965(a) addition less the IRC Sec. 965(c) subtraction is included on Form 1040, Line 21 (other income), and therefore, is includible in the adjusted gross income calculation on Line 37.
Estates and Trusts
To the extent that the IRC Sec. 965(a) addition less the IRC Sec. 965(c) subtraction is distributed to a beneficiary, such net amount is included on Form 1041, Line 8 (other income).
To the extent that such net amount is not distributed to a beneficiary, the IRC Sec. 965(a) addition is not reflected on Form 1041. Instead, this amount is included on IRC Sec. 965 Transition Tax Statement, Line 1.
The IRC Sec. 965(c) subtraction is not reflected on Form 1041, but this amount is included on IRC Sec. 965 Transition Tax Statement, Line 3.
The “net tax liability” calculated on the Transition Tax Statement (incorporating the IRC Sec. 965(a) addition and the IRC Sec. 965(c) subtraction, with other adjustments) is included on Form 1041, Schedule G, Line 7, which is reflected on Form 1041, Line 23 (total tax).
To the extent that a taxpayer defers the tax over eight years, Form 1041, Line 24a (total payments and refundable credits) is used to reflect amounts to be paid in tax years beyond 2017.
State Return Treatment
With that background on the requirements contained in the IRS guidance, the potential state income tax implications resulting from the repatriation are now examined.
Prior to the release of the IRS guidance, the treatment of the IRC Sec. 965(a) and 965(c) amounts on state corporation income tax returns was already uncertain, requiring evaluation of numerous issues. The first question to be addressed is whether the state conforms to the IRC as of December 22, 2017 or later for the 2017 tax year. “Rolling” states are current with the IRC, and therefore conform to all changes unless such states selectively decouple from certain provisions, while “static” states conform to the IRC as of a specific date. If that specific conformity date is before December 22, 2017, then the state does not conform to the repatriation provisions and hence, cannot include repatriation amounts on the corporation income tax return.
Once the IRC conformity date is determined for a particular state, to the extent the state conforms to new IRC Sec. 965, several additional questions which are fraught with a great deal of uncertainty must be considered and resolved, including:
- Is the addition amount under IRC Sec. 965(a) considered to be Subpart F income, or otherwise classified as a dividend?
- Is the subtraction amount under IRC Sec. 965(c) considered a special deduction?
- If the subtraction amount is not incorporated into the state tax base, are state-specific dividends received deductions, Subpart F deductions or foreign sourcing income exclusions available?
- To the extent an income inclusion remains in the state tax base, is such income classified as business income included in the sales factor, business income excluded from the sales factor, or nonbusiness income?
- If includible in the sales factor, or if classified as nonbusiness income, how could such income be sourced?
- Is the federal deferral election ineffective at the state level?
- Could a state decide to implement its own surtax based on the federal deemed repatriation amount to the extent it does not conform to IRC Sec. 965?
As one can imagine, the answers to many (but not necessarily all) of these questions will be revealed over time as state legislatures and tax authorities address the effect of repatriation.
The IRS guidance gives rise to very complex questions that need to be considered immediately following the conformity date question. Since the IRC Sec. 965(a) and 965(c) amounts are not reported as income or a component of Form 1120 Line 28 or Line 30 income, the potential exists for states to be prevented from including repatriation amounts in the corporate income tax base. Most states conform to the IRC, and typically base their state taxable income calculations on federal taxable income, which is a measure of income that is generally reported on Form 1120 Line 28 or Line 30. Some (but not all) state statutes define their starting point as the amount of taxable income reported to the federal government, or as taxable income as defined under the IRC. In contrast, some state regulations and many form instructions refer to specific lines located on Form 1120 (such as Line 28 and Line 30) as the proper measure of the starting point.
As the IRS guidance requires corporations to complete an “off-return” worksheet that effectively calculates a separate tax that is included on Form 1120, Line 31, the repatriation amounts are not reported on Line 28 or Line 30. Accordingly, the question created by the IRS guidance is the following: does the IRS guidance requiring calculation of the repatriation amounts on an “off-return” basis require exclusion of the repatriation amount on the state corporation income tax return?
As many states have planned for repatriation to bring in considerable amounts of revenue in the next several months, it is unlikely that they will simply accept the IRS guidance to require exclusion of the repatriation amounts from the state corporation income tax base. States could argue that their statutes provide the necessary tie-in to the repatriation calculation, and that no further action is necessary to allow for full conformity with repatriation. Alternatively, states could argue that a special addition modification to the tax base is required to be made by the taxpayer, as the intent of the repatriation was to reflect an additional amount to federal taxable income, even though the IRS guidance does not allow for a taxpayer to make this reflection in its calculation of Form 1120 Line 28 or Line 30. Finally, states could look to their legislatures to specifically adopt an addition modification or a state-specific surtax, though these methods could run into political difficulties and would need to be done on a retroactive basis.
In contrast to the method required of C corporations, S corporations must report income and deductions on Schedule K, which are reported to their shareholders based on their respective shares of the S corporation profits and losses. States that recognize S corporations as such typically will follow the federal reporting of income and deductions as reflected on Schedule K, so that the repatriation amount should flow through from the S corporation to its shareholders for state income tax purposes.
Likewise, partnerships are required to report income and deductions on Schedule K, which are reported to their partners based on their respective shares of the partnership profits and losses. States typically will follow the federal reporting of income and deductions as reflected on Schedule K, so that the repatriation amount should flow through from the partnership to its partners for state income tax purposes.
As the repatriation amount is reported on Form 1040, Line 21, such amount should be captured on substantially all state individual income tax returns, which generally conform to Form 1040, Line 37 (adjusted gross income).
Estates and Trusts
The state tax treatment of the repatriation amount with respect to estates and trusts is dependent upon whether such amount is distributed to a beneficiary. If a beneficiary receives a distribution, such amount generally should be captured on state tax returns. If not, and the repatriation is reported on an off-return basis, the treatment of such amount may be subject to the very complex analysis described with respect to C corporation treatment.
Taxpayers should carefully consider how states will treat income that is repatriated under IRC Sec. 965. Based on the initial state responses to the IRC Sec. 965 guidance issued by the IRS, states are following different approaches. Therefore, it is critical that taxpayers monitor state developments concerning adoption of the IRC and the treatment of IRC Sec. 965 income.
The Illinois Department of Revenue has issued guidance explaining that income under IRC Sec. 965 must be included when determining Illinois base income, but the state’s subtraction modification for foreign dividends will exclude a portion of the increase from the Illinois base income for certain taxpayers.7
Specifically, for Illinois corporate filers, the net IRC Sec. 965 income (IRC Sec. 965(a) amount less IRC Sec. 965(c) deduction) reported on Schedule M, Other Additions and Subtractions, qualifies for the foreign dividend subtraction modification under Illinois law.8
However, Illinois does not follow either the election under IRC Sec. 965(h) to pay the tax in installments over eight years, or the election under IRC Sec. 965(i) that allows S corporation shareholders to defer payment of the tax liability until the taxable year which includes a triggering event.
In contrast, Utah recently enacted legislation adding a new statute that specifically allows taxpayers to make the installment election under IRC Sec. 965(h).9
By doing so, it appears that Utah is assuming that its starting point incorporates the IRC Sec. 965 repatriation amount. However, Utah’s starting point of “unadjusted income” does not necessarily lead one to that conclusion. The term “unadjusted income” is defined as “federal taxable income as determined on a separate return basis before intercompany eliminations as determined by the Internal Revenue Code, before the net operating loss deduction and special deductions for dividends received.”10
This definition implies that the Utah starting point is Line 28 of Form 1120, which can be problematic based on the recently issued IRS guidance requiring reporting of IRC Sec. 965 amounts on an “off-return” basis.
The New Jersey Division of Taxation issued guidance clarifying that for New Jersey corporation business tax (CBT) purposes, the deemed repatriation dividends are excluded from entire net income.11
If a corporation does not meet the ownership thresholds, the deemed repatriation dividends will be included in entire net income to the extent provided by the federal tax reform legislation.12
Again, a closer look at New Jersey’s starting point may give taxpayers pause as to whether IRC Sec. 965 amounts should be reported in the New Jersey CBT base. New Jersey’s Tax Court has examined the statutory definition of “entire net income” that provides “entire net income shall be deemed prima facie to be equal in amount to the taxable income, before net operating loss deduction and special deductions, which the taxpayer is required to report . . . to the United States Treasury Department for the purpose of computing its federal income tax.”13
The Tax Court has ruled that entire net income is limited to Line 28 (or its equivalent) on a corporation’s federal tax return.14
Most recently, the Tennessee Department of Revenue has issued guidance on repatriated earnings subject to the transition tax.15
Because corporations report repatriated earnings on the Transition Tax Statement rather than Form 1120, they should not include repatriated earnings in the net earnings calculation on Schedule J-4, Computation of Net Earnings for Entities Treated as Corporations and Other Entities. Furthermore, the repatriated earnings should not be deducted as dividends or included in the apportionment formula. This treatment is consistent with the Tennessee conformity statute that impliedly uses Line 28 as the starting point.16
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