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US Tax Reform

IRS guidance on Tax Act’s deemed repatriation rules and constructive ownership changes

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

IRS has issued a Notice and accompanying News Release that provide guidance regarding: a) Code Sec. 965, which was enacted into law by the Tax Cuts and Jobs Act (the Act) and which requires certain foreign corporations to increase their subpart F income, for their last tax year that begins before Jan. 1, 2018, by the amount of their deferred foreign income; and b) the Act’s repeal of Code Sec. 958(b)(4), which, before its repeal, had limited the effect of a constructive ownership rule.

Background—Code Sec. 965 repatriation. Code Sec. 965, as newly enacted by the Act, imposes a transition tax on untaxed foreign earnings of foreign subsidiaries of U.S. companies by deeming those earnings to be repatriated.

More specifically, Code Sec. 965(a) provides that, for the last tax year of a deferred foreign income corporation (“DFIC”) that begins before Jan. 1, 2018 (such year of the DFIC, the “inclusion year”), the subpart F income of the corporation (as otherwise determined for such tax year under Code Sec. 952) is increased by the greater of (1) the accumulated post-’86 deferred foreign income of such corporation determined as of Nov. 2, 2017, or (2) the accumulated post-’86 deferred foreign income of such corporation determined as of Dec. 31, 2017 (each such date, a “measurement date,” and the greater of the accumulated post-’86 deferred foreign income of the corporation as of the measurement dates, the “Code Sec. 965(a) earnings amount”). Furthermore, under Code Sec. 965(b)(1), the Code Sec. 965(a) earnings amount which would otherwise be taken into account under Code Sec. 951(a)(1) by a U.S. shareholder with respect to a DFIC is reduced by the amount of such U.S. shareholder’s aggregate foreign earnings and profits (E&P) deficit which is allocated to such DFIC under Code Sec. 965(b)(2).

The term “aggregate foreign E&P deficit” means, with respect to any U.S. shareholder, the lesser of: (I) the aggregate of such shareholder’s pro rata shares of the specified E&P deficits of the E&P deficit foreign corporations of such shareholder; or (II) the aggregate of such shareholder’s pro rata shares of the Code Sec. 965(a) earnings amounts of all DFICs of such shareholder. (Code Sec. 965(b)(3)(A)(i)) The term “E&P deficit foreign corporation” means, with respect to any taxpayer, any specified foreign corporation with respect to which such taxpayer is a U.S. shareholder, if, as of Nov. 2, 2017, (i) such specified foreign corporation has a deficit in post-’86 earnings and profits, (ii) such corporation was a specified foreign corporation, and (iii) such taxpayer was a U.S. shareholder of such corporation. (Code Sec. 965(b)(3)(B)) The term “specified E&P deficit” means, with respect to an E&P deficit foreign corporation, the amount of such corporation’s deficit in post-’86 earnings and profits as of Nov. 2, 2017. (Code Sec. 965(b)(3)(C))

For purposes of Code Sec. 965, a DFIC is, with respect to any U.S. shareholder, any specified foreign corporation of such U.S. shareholder that has accumulated post-’86 deferred foreign income (as of a measurement date) greater than zero.Code Sec. 965(e)(1) provides that the term “specified foreign corporation” means (A) any controlled foreign corporation (CFC), and (B) any foreign corporation with respect to which one or more domestic corporations is a U.S. shareholder.

A U.S. shareholder of a DFIC is allowed a deduction for the tax year in which the above rules apply in an amount equal to the sum of: (i) the U.S. shareholder’s 8% rate equivalent percentage of the excess (if any) of: (a) the amount so included as gross income, over (b) the amount of the U.S. shareholder’s aggregate foreign cash position, plus (ii) the U.S. shareholder’s 15.5% rate equivalent percentage of so much of the amount described in item (i)(b) (above) as does not exceed the amount described in item (i)(a) (above). (Code Sec. 965(c)(1))

The 8% rate equivalent percentage is, as to any U.S. shareholder for any tax year, the percentage which would result in the amount to which that percentage applies being subject to a 8% rate of tax determined by only taking into account a deduction equal to that percentage of the amount and the highest rate of tax specified in Code Sec. 11 for the tax year. (Code Sec. 965(c)(2)(A)) The 15.5% rate equivalent percentage is, with respect to any U.S. shareholder for any tax year, the percentage determined under the 8% equivalent percentage definition applied by substituting a 15.5% rate of tax for the 8% rate of tax. (Code Sec. 965(c)(2)(B))

The term “aggregate foreign cash position” means, with respect to any U.S. shareholder, the greater of (i) the aggregate of such U.S. shareholder’s pro rata share of the cash position of each specified foreign corporation of such U.S. shareholder determined as of the close of the inclusion year or (ii) a somewhat similar calculation involving earlier tax years. Each date used in this calculation is a “cash measurement date.”

The cash position of any specified foreign corporation includes, among other things, the net accounts receivable (receivables net of payables) of such corporation and any obligation with a term of less than one year (“short-term obligation”). (Code Sec. 965(c)(3)(B))

Background—repeal of Code Sec. 958(b)(4) (constructive ownership rule). Code Sec. 958 provides rules for determining stock ownership of a foreign corporation for purposes of Code Sec. 951 through Code Sec. 965. Code Sec. 958(b) provides that Code Sec. 318(a) (dealing with constructive ownership of stock) applies, subject to certain modifications, to the extent that the effect is to treat any U.S. person as a U.S. shareholder within the meaning of Code Sec. 951(b) or to treat a foreign corporation as a CFC under Code Sec. 957.

Effective for the last tax year of foreign corporations beginning before Jan. 1, 2018, and each subsequent year of such foreign corporations, and for the tax years of U.S. shareholders in which or with which such tax years of foreign corporations end, the Act repeals former Code Sec. 958(b)(4).

As a result of this repeal, stock of a foreign corporation owned by a foreign person can be attributed to a U.S. person under Code Sec. 318(a)(3) for purposes of determining whether such U.S. person is a U.S. shareholder of the foreign corporation and, therefore, whether the foreign corporation is a CFC. In other words, as a result of the repeal of former Code Sec. 958(b)(4), Code Sec. 958(b) now provides for “downward attribution” from a foreign person to a U.S. person in circumstances in which Code Sec. 958(b), before the Act, did not so provide. As a result, foreign corporations that were not previously treated as CFCs may be treated as CFCs.

Background—Code Sec. 863. Code Sec. 863 and the regs thereunder provide special rules for determining the source of certain items of gross income, including gross income from space and ocean activities and international communications income. Code Sec. 863(d) provides that, except as provided in regs, any income derived from a space or ocean activity by a U.S. person is sourced in the U.S. (such income, “U.S. source income”) and that any space and ocean income derived by a foreign person is sourced outside the U.S. (such income, “foreign source income”). Reg. § 1.863-8(b)(3)(ii) includes an exception from the statutory provision regarding space and ocean income derived by a foreign person if the foreign person is a CFC.

In the case of any U.S. person, 50% of any international communications income (as defined in Code Sec. 863(e)(2)) is treated as U.S. source income, and 50% of such income is treated as foreign source income. (Code Sec. 863(e)(1)(A)) Reg. § 1.863-9(b)(2)(ii) provides that international communications income derived by a CFC is treated as one-half U.S. source and one-half foreign source.

Background—Form 5471. Pursuant to Code Sec. 6038(a)(4), IRS may require any U.S. person treated as a U.S. shareholder of a CFC to file an information return on Form 5471, “Information Return of U.S. Persons with Respect to Certain Foreign Corporations,” with respect to its ownership in such CFC. For this purpose, a U.S. shareholder is defined in Code Sec. 951(b), and the U.S. shareholder’s ownership in a CFC is determined based on direct and indirect ownership under Code Sec. 958(a) and constructive ownership under Code Sec. 958(b). Under the Instructions for Form 5471 (Rev. Dec. 2017), a U.S. shareholder who owns stock in a CFC for an uninterrupted period of 30 or more days during the CFC’s tax year and owned the stock on the last day of that year must file Form 5471.

New guidance with respect to Code Sec. 965. The Notice provides that IRS will be issuing regs on various subjects including the following:

… Determination of status of a specified foreign corporation as a DFIC or an E&P deficit foreign corporation. IRS intends to issue regs providing that, for purposes of determining the status of a specified foreign corporation as a DFIC or an E&P deficit foreign corporation, it must first be determined whether the specified foreign corporation is a DFIC. If the specified foreign corporation meets the definition of a DFIC, it is classified solely as a DFIC and not also as an E&P deficit foreign corporation, even if such specified foreign corporation otherwise satisfies the requirements of Code Sec. 965(b)(3)(B). If a specified foreign corporation does not meet the definition of a DFIC, the U.S. shareholder must then determine whether it is an E&P deficit foreign corporation. In some cases, a specified foreign corporation may be classified as neither a DFIC nor an E&P deficit foreign corporation, despite having post-’86 earnings and profits greater than zero or a deficit in accumulated post-’86 deferred foreign income.

… Determination of aggregate foreign cash position. Code Sec. 965(c)(3)(C) does not define the term “accounts receivable” for purposes of the term “net accounts receivable.” IRS intends to issue regs providing that, for purposes of Code Sec. 965(c)(3)(C), the term “accounts receivable” means receivables described in Code Sec. 1221(a)(4), and the term “accounts payable” means payables arising from the purchase of property described in Code Sec. 1221(a)(1) or Code Sec. 1221(a)(8) or the receipt of services from vendors or suppliers. Receivables that are treated as accounts receivable within the meaning of Code Sec. 965(c)(3)(C)(i) will not also be treated as short-term obligations.

IRS intends to issue regs providing that, for purposes of determining a specified foreign corporation’s cash position, a loan that must be repaid on the demand of the lender (or that must be repaid within one year of such demand) will be treated as a short-term obligation, regardless of the stated term of the instrument.

New guidance with respect to repealed Code Sec. 958(b)(4). IRS has determined that, in light of the change to the constructive ownership rules in Code Sec. 958(b), further study is necessary to determine whether it is appropriate for the source of income described in Code Sec. 863(d) and Code Sec. 863(e) to be determined by reference to the status of the recipient as a CFC.

Accordingly, for purposes of applying Reg. § 1.863-8 and Reg. § 1.863-9, taxpayers may determine whether a foreign corporation is a CFC without regard to the repeal of Code Sec. 958(b)(4) pending further guidance (which will be prospective).

As noted above, Code Sec. 958(b) now provides for “downward attribution” from a foreign person under Code Sec. 318(a)(3) to a U.S. person in circumstances in which Code Sec. 958(b), before the Act, did not so provide. A U.S. shareholder’s pro rata share of a CFC’s subpart F income and the amount determined under Code Sec. 956 that a U.S. shareholder is required to include in gross income, however, continue to be determined based on direct and indirect ownership of the CFC under Code Sec. 958(a), which does not take into account such downward attribution.

IRS intends to amend the Instructions for Form 5471 to provide an exception for a U.S. person that is a U.S. shareholder with respect to a CFC if no U.S. shareholder (including such U.S. person) owns, within the meaning of Code Sec. 958(a), stock in such CFC, and the foreign corporation is a CFC solely because such U.S. person is considered to own the stock of the CFC owned by a foreign person under Code Sec. 318(a)(3).

Effective date. Both Code Sec. 965 and the repeal of Code Sec. 958(b)(4) are effective for the last tax years of foreign corporations that begin before Jan. 1, 2018, and with respect to U.S. shareholders, for the tax years in which or with which such tax years of the foreign corporations end.

IRS intends to issue regs that will cover the above guidance with respect to Code Sec. 965 effective beginning the first tax year of a foreign corporation (and with respect to U.S. shareholders, the tax years in which or with which such tax years of the foreign corporations end) to which Code Sec. 965 applies. Before the issuance of those regs, taxpayers may rely on the rules described under “New guidance with respect to Code Sec. 965,” above.

Taxpayers may rely on the above Code Sec. 863 rules with respect to the last tax year of foreign corporations beginning before Jan. 1, 2018, and for the tax years of U.S. shareholders in which or with which such tax years of foreign corporations end, pending the issuance of further guidance (the application of which will be prospective). Before the change to instructions described above with respect to Form 5471, taxpayers may also rely on the exception described above regarding that Form for the last tax year of foreign corporations beginning before Jan. 1, 2018, and each subsequent year of such foreign corporations and for the tax years of U.S. shareholders in which or with which such tax years of foreign corporations end.

References: For source of income from space, oceans, and international communications, see FTC 2d/FIN ¶ O-10976, FTC 2d/FIN ¶ O-10984; United States Tax Reporter ¶ 863.04, United States Tax Reporter ¶ 8634.045. Notice 2018-13, 2018-6; IR 2018-9

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