By Nicole Suk, CPA
February 5, 2019
As the 2018 tax filing season falls upon us, you and your accountants have most likely already dealt with the Sec. 965 transition tax (also commonly known as the toll tax or repatriation tax). You believe that all of it is behind you. Nothing more to do. However, as with most of the recent tax reform, the Treasury Department is still releasing final guidance and regulations. When preparing 2017 tax returns, CPAs were dependent upon proposed regulations and temporary guidance. The transition tax was one of the few parts of tax reform that was effective for 2017 tax filers. So, did your CPA get it right? Maybe and maybe not.
On Dec. 22, 2017, as part of the sweeping tax reform better known as the Tax Cuts and Jobs Act (TCJA), PL.115-97, President Trump signed into law his initial attempt at a transition of the U.S. tax system from a worldwide system to a Participation Exemption Tax System. Under pre-TCJA law, U.S. citizens, resident individuals, and domestic corporations generally were taxed on their worldwide income (income earned in the United States or abroad). Foreign income earned by a Controlled Foreign Corporation (CFC) of certain U.S. “persons” (corporations, individuals, partnerships, trusts, or estates) generally was not subject to U.S. tax until the income was distributed as a dividend to the U.S. person (or treated as a deemed dividend under Subpart F). As a result, U.S. corporations were holding trillions of dollars offshore in fear of the maximum 35-percent U.S. corporation tax rate being imposed on what was already foreign taxed income.
The Sec. 965 transition tax changed this. Under the new tax law, U.S. shareholders of a deferred foreign income corporation (DFIC) were required to include in their income for the DFIC’s last tax year (or transition year) before Jan. 1, 2018 (including fiscal-year filers with tax years ending before Jan 1, 2018), the U.S. shareholder’s pro rata share of its deemed repatriated earnings or the Section 965 earnings amount. This means that for the calendar year Dec. 31, 2017 taxpayers, the currently deferred and un-repatriated CFC earnings were taxed on the 2017 tax returns, regardless of whether the cash was actually brought back to the United States.
The TCJA also brought with it a permanently reduced corporate tax rate of 21 percent from the previously possible top tax rate of 35 percent. This reduction alone may have triggered some U.S. taxpayers to repatriate their earnings voluntarily. However, TCJA took the sting out of the required transition tax a bit more by reducing the tax rate on those repatriated earnings down to either an 8-percent or 15.5-percent rate depending on the form in which the earnings were held (cash or non-cash equivalents). An election was also available to pay the tax liability in installments over a period of eight years.
So now that returns have been filed, and the tax has been calculated, reported and at least partially paid, the IRS released final regulations on the Sec. 965 transition tax on Jan. 15, 2019. Fortunately for all us CPAs out there, the final regs retain the basic approach and structure of the proposed regs, with just a few certain revisions. The new guidance generally adopts the regulations proposed in August 2018, but also contains several targeted changes that correct nuances or clarify ambiguities in the proposed regulations. Now at least taxpayers do have some certainty. This lack of final rules impacted financial reporting and hindered the ability to accurately calculate the Sec. 965 liability for both 2017 and 2018 tax years.
The most notable parts of the final regulations include:
- Retention of the definitions of “aggregate foreign cash position” and “cash position” set out in the proposed regs. with a few differences:
- Determination of the aggregate foreign cash position of a consolidated group
- Excluding certain commodities from the cash position of a specified foreign corporation (SFC)
- Excluding some forward contracts and short positions with respect to such commodities
- Clarification that a controlled domestic partnership treated as a foreign partnership is treated as a foreign pass-through entity for Sec. 965 purposes
- Modification of the “element” test with respect to the rule that disregards certain accounting method changes
- Requirements related to SFCs that ceased to be an SFC during the transition year
- Explanation of the inclusion ordering rules and the “specified payment” rule that now makes it optional to disregard certain payments between SFCs
- Limitation of downward-basis adjustments to the stock of an E&P deficit foreign corporation and providing a basis adjustment election
- Provision of an increased de minimis threshold for downward attribution to partnerships
- Clarification with respect to foreign taxes and allowance credits
- Allocation of specified E&P deficits in cases involving common stock with no liquidation value
Now What? Though the changes appear aimed at certain areas, taxpayers should carefully evaluate them. The rules could impact a number of taxpayers in both positive and negative ways. In some cases, taxpayers may be able to amend 2017 returns or modify their 2018 computations to reduce their overall Sec. 965 tax liability.
The rules are generally retroactively effective 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’ end). However, some items such as the effective date for the section 965(h) election relating to “transfer agreements” will not become effective until 30 days after the date when the final regulations are published in the Federal Register.
With the recent partial government shutdown, the Federal Register was not timely published. Therefore, the deadline for this election will likely be delayed until at least 90 days from when a final government spending deal is reached. Assuming the regulations are officially published prior to June 2019, any provisions with the clear effective date tied to Jan. 1, 2018, should be unaffected by the delayed publication of the final regulations in the Federal Register.
For post calculation and payment of the Sec. 965 transition tax, there are a few key items to keep in mind:
- Any dividend distributions received after Dec. 31, 2017 from a DFIC, by a U.S. corporate 10-percent shareholder, is eligible for a 100-percent dividend received a deduction of the foreign sourced portion of the dividend. This only applies to C-corporation owners. S-corporation and individual owners will still pay taxes on dividends from CFCs.
- If you elected to pay the taxes over the allowable 8-year installment period, don’t forget to include the tax on the 2018 returns and pay any required estimated tax payments.
- If you were an S corporation that elected to defer the tax, be mindful of any triggering events that may create immediate Sec. 965 tax liabilities.
- If your 2017 returns were not prepared correctly, be sure to amend to take advantage of any beneficial changes included in the final Sec. 965 regulations.
- Beware if you have any regular income tax overpayments on your returns. If you elected to pay the transition tax over the 8-year installment period, refunds of regular income tax may no longer be available, nor will overpayments be a credit to next year’s income tax liability. Instead, overpayments will be offset against your Sec. 965 liability that would otherwise be payable in installments. In addition, taxpayers who may have filed refund claims for 2017 and who have not yet received them should inquire with the IRS as to whether such refunds will be issued.
If you have any questions regarding the Sec. 965 transition tax and how it may affect you, contact Nicole Suk at firstname.lastname@example.org.