Treasury Issues Guidance on Transition Tax under Section 965

On August 1, the Treasury Department issued proposed regulations relating to the Section 965 transition tax created by the Tax Cuts and Jobs Act (TCJA).  The TCJA changed the way U.S. companies are taxed on their foreign earnings and the transition tax bridges the gap between the old and new rules.

Under the old rules, U.S. companies had to pay residual taxes when they repatriated earnings from low-tax foreign jurisdictions.  This incentivized U.S. companies to keep such earnings abroad. According to the Joint Committee on Taxation, approximately $2.6 trillion of untaxed foreign income has been stockpiled abroad by U.S. corporations.

Under the new rules, U.S. companies repatriating foreign earnings will receive a 100-percent dividend received deduction, which means such income will be exempt from U.S. taxation (unless certain anti-abuse rules apply). The new rules represent a territorial-style tax system instead of a worldwide approach.

The transition from a worldwide tax system to a territorial-style tax system required a provision that would differentiate between the untaxed foreign earnings stockpiled abroad under the old rules and the post-tax reform foreign earnings that are provided an exemption from U.S. tax. Section 965 makes this distinction by establishing a one-time deemed repatriation of all untaxed foreign earnings accrued as of the last taxable year before January 1, 2018.

The untaxed foreign earnings are divided into two categories—(1) cash and cash equivalents and, (2) all other assets.  The tax on cash and cash equivalents is 15.5% and the tax on all other assets is 8%.

The fictional repatriation created by Section 965 means some companies may not have the wherewithal to pay the new tax all at one time. Policymakers accounted for this issue by establishing an installment payment option that allows taxpayers to remit payment over an eight-year period.

Taxpayers have been waiting for guidance to get a better understanding of how certain elections will work, and to gain insight into how the new provision will interact with existing provisions like the foreign tax credit. The proposed guidance provides taxpayers with additional information in the following areas:

1. General rules and definitions
2. Determination and treatment of deductions
3. Disregarded transactions
4. Foreign tax credit treatment
5. Elections and payments
6. Affiliated and consolidated group rules
7. Dates of applicability

Below are three excerpts relating to S corporations, the foreign tax credit, and the installment payment option that will be relevant for many taxpayers.

S Corporations

The proposed guidance confirms that, in the case of any S corporation that is considered a U.S. shareholder, each shareholder of the S corporation may elect to defer payment of the shareholder’s net tax liability under Sec. 965 with respect to the S corporation until the shareholder’s tax year which includes the triggering event with respect to such liability.

The guidance offers additional detail by establishing the process that should be followed when a triggering event occurs.

If a triggering event occurs, Code Sec. 965(i)(4) permits a taxpayer to make an election under Code Sec. 965(h) with respect to the liability to which the Code Sec. 965(i) election applied by the due date for the return of tax for the tax year in which the triggering event occurred, and the first installment under Code Sec. 965(h) must also be paid by the due date (without regard to extensions) for the return for the tax year of the triggering event. However, the election may only be made with IRS’s consent in the case of a triggering event that is a liquidation or sale of substantially all of the assets of the S corporation. (Code Sec. 965(i)(4)(D))

Foreign Tax Credit

The guidance also provides insight into the interaction with the foreign tax credit. The rules state that no credit is allowed under Sec. 901 for the applicable percentage of any taxes paid or accrued with respect to any amount for which a section 965(c) deduction is allowed.

The term “applicable percentage” means the amount (expressed as a percentage) equal to the sum of the following two amounts: 

1. 0.771 multiplied by the ratio of 
   1. The section 965(a) inclusion amount in excess of the U.S. shareholder’s aggregate foreign cash position divided by
   2. The section 965(a) inclusion amount, and
2. 0.557 multiplied by the ratio of 
   1. The amount of the section 965(a) inclusion amount equal to the United States shareholder’s aggregate cash position, divided by
   2. The section 965(a) inclusion amount.

Further, no deduction is allowed for any tax for which credit is not allowable under Code Sec. 901 by reason of Code Sec. 965(g)(1) (determined by treating the taxpayer as having elected the benefits of subpart A of part III of subchapter N).

Installment Payments

With respect to the installment payment option, a U.S. shareholder may elect to pay, in eight installments, the “net tax liability” under Sec. 965, defined as the excess (if any) of:

1. The taxpayer’s net income tax for the tax year in which an amount is included in the gross income of the shareholder under Code Sec. 951(a)(1) by reason of Code Sec. 965, over
2. The taxpayer’s net income tax for such tax year determined 
   1. Without regard to Code Sec. 965, and
   2. Without regard to any income or deduction properly attributable to a dividend received by the shareholder from any DFIC. (Code Sec. 965(h)(6))

For this purpose, the term “net income tax” means the regular tax liability reduced by the credits allowed under subparts A, B, and D of part IV of subchapter A. (Code Sec. 965(h)(6)(B))

If a taxpayer makes an election under Code Sec. 965(h), the first installment is due on the due date (without regard to extensions) for the return of tax for the inclusion year (Code Sec. 965(h)(2)) and each successive installment is due on the due date (without regard to extensions) for the return of tax for the tax year following the tax year for which the previous installment payment was made.

Tara Fisher has been practicing international tax for nearly 20 years. Her professional background includes working for the U.S. Congress Joint Committee on Taxation, the national tax practice of PricewaterhouseCoopers, the University of Pittsburgh, and American University in Washington D.C. She is a licensed CPA and holds both an undergraduate and graduate degree in accounting from the University of Virginia.