Transition Tax – Proposed Regulations Are Here

The Treasury Department and the I.R.S. recently published proposed regulations on Code §965 (the "Proposed Regulations"). Introduced by the Tax Cuts and Jobs Act of 2017 ("T.C.J.A."), Code §965 requires a "U.S. Shareholder" (see in detail below) to pay income tax on its pro rata share of previously untaxed foreign earnings held in a controlled foreign corporation ("C.F.C.") and in certain other foreign corporations.1 The tax imposed by Code §965 is commonly referred to as the transition tax. It is designed to tax deferred foreign income prior to the transition to a "participation exemption" system of taxation for the foreign portion of dividends from C.F.C.'s and certain other foreign corporations and, hence, is also a "toll tax."2 Because this tax is imposed irrespective of whether profits of a qualifying foreign corporation are actually distributed to its U.S. Shareholders, it is also referred to as a "mandatory repatriation tax."

Prior to the Proposed Regulations, the Treasury Department and I.R.S. issued guidance on this new Code provision under Notices 2018-7,3 2018-13,4 and 2018-265 and Revenue Procedure 2018-17.6 The Proposed Regulations generally follow the prior guidance but, in addition, provide long awaited clarification on calculation, special election, and payment procedures.

CODE §965 BACKGROUND

In order to discuss the calculation and the workings of Code §965, several significant terms must be understood.

Transition tax applies to an S.F.C. that is a "deferred foreign income corporation" ("D.F.I.C.").7

An S.F.C. is (i) any C.F.C. and (ii) any foreign corporation in which one or more U.S. corporations is a U.S. Shareholder.8 For Code §965 purposes, a U.S. Shareholder is a U.S. person (e.g., a citizen, resident, corporation, partnership, trust, or estate) that owns 10% or more of the vote of the foreign corporation.9 A C.F.C. is a foreign corporation in which one or more U.S. Shareholders own more than 50% of the voting rights of all of the classes of stock that are entitled to vote.

A D.F.I.C. is an S.F.C. that has "accumulated post-1986 deferred foreign income" on one of two possible measurement dates, discussed below. Accumulated post-1986 deferred foreign income is "post-1986 E&P" defined below, but excludes earnings attributable to income effectively connected to a U.S. trade or business10 or, in the case of a C.F.C., income that, if distributed to a U.S. Shareholder, would have been previously subject to U.S. taxation under the rules applicable to C.F.C.'s.11

Post-1986 E&P is E&P of the foreign corporation computed under the applicable rules and accumulated in tax years beginning after December 31, 1986, through one of the two applicable measurement dates, discussed below. The amount is determined without a reduction for dividends distributed during the tax year. This reflects the general ordering rule of Subpart F and actual dividends - Subpart F applies first, and dividends are not taxed a second time if and to the extent attributable to previously taxed income. For individual U.S. Shareholders, this means they are taxed at ordinary income rates and not favorable long-term capital gains tax rates that might otherwise apply to qualified dividends.

The transition tax applies to the last tax year of a D.F.I.C. that begins before January 1, 2018. For that tax year, the Subpart F Income under Code §951 (also referred to as a Code §951 inclusion) of a D.F.I.C. must be increased by the greater of its accumulated post-1986 deferred foreign income as of November 2, 2017, or December 31, 2017, (the "E&P measurement dates"). The increase in income is the "Code §965(a) earnings" amount. The U.S. Shareholder must treat the increase as Subpart F Income.

Under Code §965(b), if a U.S. Shareholder is a shareholder of at least one D.F.I.C. and at least one foreign corporation that has an E&P deficit (an "E&P deficit foreign corporation"), the increase in income discussed above is reduced (but not below zero) by the U.S. Shareholder's aggregate foreign E&P deficit. This amount is the "Code §965(a) inclusion" amount. The amount by which the foreign E&P deficit decreased the Code §965(a) earnings amount is treated as previously taxed income ("P.T.I.") under the rules of Code §959.

Instead of prescribing a fixed tax rate on the Code §951 inclusion, Code §965 allows a deduction to be applied to net income that is calculated to achieve a specific tax rate. This is referred to as the rate equivalent percentage method. In substance, the equivalent of a partial D.R.D. is computed so that the tax imposed will equal the target rate when divided by net income before the deduction.

The effective tax rates applicable to income inclusions under this rule are adjusted by way of a deduction set forth in Code §965(c). In other words, the "exemption" is in the form of a partial deduction (the "Code §965(c) deduction"). As a result, the Code §965 deduction results in a partial "exemption" of the Code §965 inclusion amount. The Code §965(c) deduction is an amount necessary to produce a 15.5% tax rate on accumulated post-1986 E&P held in the form of cash or cash equivalents and an 8% tax rate on all other earnings. The foreign tax credit is not allowed for the applicable percentage of foreign taxes paid or accrued (or treated as paid or accrued) with respect to any amount for which a Code §965(c) deduction is allowed.

Code §965 permits the taxpayer to make certain elections. Under Code §965(h), a U.S. Shareholder may elect to defer payment of the transition tax liability by paying the amount in installments over eight years. The first five installments must each equal 8% of the transition tax liability; the sixth installment must equal 15%; the seventh installment must equal 20%; the eighth and final installment must equal 25%. The installment payments are not subject to an interest charge. Certain "acceleration events" will cause the taxpayer to lose the benefit of deferral by accelerating the payment of the unpaid portion of all remaining installments to the date of the acceleration event, discussed under Elections and Payments below. Note that although the payment of the net tax liability under Code §965 is deferred, the amount must be reported on an IRC 965 Transition Tax Statement.

In the case of an S-corporation that is a U.S. Shareholder of a D.F.I.C., Code §965(i) permits each shareholder of the S-corporation to elect to defer payment of the transition tax liability until a "triggering event." A triggering event occurs when the corporation ceases to be an S-corporation or is sold or liquidated, or the taxpayer transfers stock of the S-corporation (including a transfer by death).

STEP-BY-STEP CALCULATION OF THE TRANSITION TAX

Based on the foregoing, determining the amount of transition tax requires the following steps:

Measure post-1986 E&P of S.F.C.'s. Allocate E&P deficits. Calculate aggregate foreign cash position or cash equivalent amounts. Compute allowed deductions under Code §965(c). Determine foreign tax credits. THE PROPOSED REGULATIONS

Definitions

The following definitions are addressed in the Proposed Regulations. These definitions generally are consistent with prior guidance.

E&P Deficit Foreign Corporation - For purposes of determining the status of an S.F.C. as a D.F.I.C. or an E&P deficit foreign corporation, it must first be determined whether the S.F.C. is a D.F.I.C. In broad terms, D.F.I.C. status trumps classification as an E&P deficit foreign corporation. More specifically, if an S.F.C. meets the definition of a D.F.I.C., it is classified solely as a D.F.I.C. and not also as an E&P deficit foreign corporation, notwithstanding the fact that the S.F.C. otherwise satisfies the E&P deficit foreign corporation definition. Thus, only in the event an S.F.C. does not meet the definition of a D.F.I.C., must it be determined whether it is an E&P deficit foreign corporation. Under certain circumstances described in the Proposed Regulations, an S.F.C. may be classified as neither a D.F.I.C. 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.12

Accumulated Post-1986 Deferred Foreign Income - In the case of a C.F.C. that has shareholders that are not U.S. Shareholders on an E&P measurement date, the accumulated post-1986 deferred foreign income of the C.F.C. on the E&P measurement date is reduced by amounts that would be those described in Code §965(d) (2)(B) if the shareholders were U.S. Shareholders. In such cases, the principles of Revenue Ruling 82-16, 1982-1 C.B. 106, apply in order to determine the amounts by which accumulated post-1986 deferred foreign income is reduced.13

Cash Measurement Dates - For the purpose of computing the Code §965(a) inclusion, the cash measurement dates are as follows:

The first cash measurement date of an S.F.C. is the close of the last tax year of the S.F.C. that ends after November 1, 2015, and before November 2, 2016, if any. The second cash measurement date of an S.F.C. is the close of the last tax year of the S.F.C. that ends after November 1, 2016, and before November 2, 2017, if any. The final cash measurement date of an S.F.C. is the close of the last tax year of the S.F.C. that begins before January 1, 2018, and ends on or after November 2, 2017, if any. The proposed regulations provide that a U.S. Shareholder takes into account its p rata share of the cash position of an S.F.C. as of any cash measurement date of t S.F.C. on which it is a U.S. Shareholder of the S.F.C., regardless of whether the U. Shareholder is a U. S. Shareholder of the S.F.C. as of any other cash measureme date, including the final cash measurement date of the S.F.C.14

Cash Position - The Proposed Regulations define the term "cash-equivalent asset" to include derivative financial instruments held by the S.F.C. that are not a bona fide hedging transaction.15 "Derivative financial...