Transition Tax, Toll Tax or Repatriation Tax: What You Need to Know

By Brandi M. Samuel, CPA

By now, you may have heard these buzz words―transition tax, toll tax or repatriation tax―blasted through the media, and hopefully from your accountant. Understandably, you may be wondering the effect this tax may have on you, your business, or your 2017 tax return filings. 
The IRS has started releasing guidance for clarification of certain inclusions or calculations, but we're still waiting for guidance on actual reporting. So, for now, let's just discuss the high-level basics of the amended IRC Section 965, “Treatment of Deferred Foreign Income Upon Transition to Participation Exemption System of Taxation.” Yes, that's the actual name of the amended code section. Let's dive in.

Background
On Dec. 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (TCJA), PL.115-97, which introduced tax reform that impacts all U.S. filers, including individuals, corporations, partnerships, trusts, and estates. One aspect of the TCJA is the transition from a worldwide tax 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 (or 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). 

New Law
Under the new law, in general, U.S. shareholders of a deferred foreign income corporation (DFIC) must 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. Subsequently, any dividend distributions received after Dec. 31, 2017 from a DFIC, by a U.S. corporate 10-percent shareholder, is eligible for a dividend received deduction of the foreign sourced portion of the dividend.
The Section 965 earnings amount is the greater of the untaxed, non-Effectively Connected Income (ECI) accumulated, post-1986 earnings and profits determined as of Nov. 2, 2017 or Dec. 31, 2017.
A DFIC is a corporation that is either: (1) A CFC; or (2) Any foreign corporation that has at least one U.S. corporation that owns at least 10 percent of the vote or value of all classes of stock of the foreign corporation (excluding Passive Foreign Investment Companies or PFICs). This is another major change under the TCJA, as the definition of a U.S. shareholder now includes any U.S. person that also owns 10 percent of the value, where previously, the ownership was limited to U.S. persons owning 10 percent of the vote of all classes of stock.

Tax Rate
The portion of the Section 965 earnings amount (after some detailed calculations) held in the form of cash or cash equivalents is taxed at a reduced rate of 15.5 percent, while any remaining earnings and profits (E&P) is taxed at a reduced rate of 8 percent (hence the terms, Transition Tax, Repatriation Tax, or Toll Tax). An election is available for the U.S. shareholder to pay the tax liability in installments over a period of eight years:
  • 8 percent of net tax liability in the first five years
  • 15 percent of net tax liability in the sixth year
  • 20 percent of net tax liability in the seventh year; and
  • 25 percent of the net tax liability in the eighth year.
S-Corporation Carve-Out
S-Corporation shareholders can elect to defer payment of the net tax liability until there is a triggering event such as: (1) A change in S-Corp status or the S Corporation ceases to conduct business; (2) A liquidation or sale of substantially all its assets; or (3) A S-Corp shareholder transfers stock (including because of death or otherwise).  Regarding partial transfers of S-Corp stock, the net tax liability is allocated to that portion of the transfer that causes the triggering event. Additionally, a transfer of stock will not be considered a triggering event if the transferee enters an agreement with the IRS claiming responsibility for the payment of the net tax liability. In the year of a triggering event, an S-Corp shareholder also has the option to make an election to pay the net tax liability in installments, as previously discussed above.
There is also a special carve-out for REITS, which is not discussed in the article. See IRC Section 965(m) for further guidance.

Other Resources
The Treasury and IRS have issued the following guidance on the Transition Tax:
  • Notice 2018-7 – The Treasury and IRS announced the intent to issue upcoming regulations for determining amounts to be included in gross income by U.S. shareholders under Code Sec. 951(a)(1);
  • Notice 2018-13 - Additional guidance under Section 965 and guidance under Sections 863 and 6038 in connection with the repeal of Section 958(b); and
  • Rev. Proc. 2018-17 - Procedural change by the IRS regarding granting approval of certain requests by certain foreign corporations for changes in annual accounting periods.
If you have any further questions regarding the proposed U.S. tax reform or how it may impact you, your business or your 2017 tax return filings, contact Brandi M. Samuel at bsamuel@windhambrannon.com.