IRS has issued highly anticipated final regs under Code Sec. 965 – the transition tax provision added to the Code by the Tax Cuts and Jobs Act (TCJA; P.L. 115-97, 12/22/2017).
Background. Code Sec. 965 generally requires U.S. shareholders to pay a “transition tax” on the untaxed foreign earnings of certain specified foreign corporations as if those earnings had been repatriated to the U.S.
Observation: The TCJA provides for a shift from the pre-2018 “worldwide” tax system to a “participation exemption system.” Under the old rules, U.S. taxpayers were generally taxed on all income whether earned in the U.S. or abroad, but foreign income earned by a foreign subsidiary of a U.S. corporation would not be subject to U.S. tax until it was “repatriated” to the U.S. via dividend. The transition tax effectively bridges the old rules with the new by taxing certain previously untaxed foreign income.
Specifically, in a specified foreign corporation’s last tax year which began before Jan. 1, 2018, the foreign corporation’s subpart F income is increased by any previously untaxed, non-effectively connected post-1986 earnings and profits (E&P) of the corporation measured as of one of two measuring dates (pre-2018 accumulated deferred foreign income). (Code Sec. 965(a)) U.S. shareholders of one or more specified foreign corporations must include in income their pro rata share of the corporation’s pre-2018 accumulated deferred foreign income less their pro rata share of any other specified foreign corporations’ E&P deficits. (Code Sec. 965(b))
A U.S. shareholder is allowed a deduction from this amount which results in a 15.5% tax rate for earnings held in cash and liquid assets, and an 8% tax rate on other earnings. (Code Sec. 965(c) A reduced foreign tax credit applies to the inclusion under Code Sec. 965(g).
Under Code Sec. 965(h), taxpayers may elect to pay the transition tax in installments over an 8-year period. Generally, a specified foreign corporation means either a controlled foreign corporation (CFC) or a foreign corporation (other than a passive foreign investment company, that is not also a CFC) that has a U.S. shareholder that is a domestic corporation.
Code Sec. 965 applies with respect to the last tax year of certain specified foreign corporations beginning before Jan. 1, 2018, and the amount included in income under this provision is includible in the U.S. shareholder’s year in which or with which such a specified foreign corporation’s year ends. Taxpayers may have had to pay tax resulting from Code Sec. 965 when filing their 2017 tax returns. For example, Code Sec. 965 may have given rise to a 2017 tax liability for a calendar year U.S. shareholder holding an interest in a calendar year specified foreign corporation.
Proposed regs under Code Sec. 965 were published in August 2018.
Final regs. The final regs retain the basic approach and structure of the proposed regs, with certain revisions.
As in the proposed regs, the final regs provide that a Code Sec. 965(a) inclusion amount is determined by translating a Code Sec. 958(a) U.S. shareholder’s pro rata share of the Code Sec. 965(a) earnings amount of a deferred foreign income corporation (DFIC) into U.S. dollars using the spot rate on Dec. 31, 2017. (Reg § 1.965-1(b)(1))
As in the proposed regs, the final regs provide that a controlled domestic partnership treated as a foreign partnership is treated as a foreign pass-through entity. (Reg § 1.965-2(i)(2))
The final regs generally retain the definitions of “aggregate foreign cash position” and “cash position” set out in the proposed regs. (Reg § 1.965-1(f)(8), Reg § 1.965-1(f)(16))
However, IRS has determined that a narrow exemption from the definition of “cash position” is appropriate for certain assets held by a specified foreign corporation in the ordinary course of its trade or business as well as for certain privately negotiated contracts to buy or sell such assets. Accordingly, the final regs provide that a commodity that is described in Code Sec. 1221(a)(1) or Code Sec. 1221(a)(8) in the hands of the specified foreign corporation is excluded from the category of personal property which is of a type that is actively traded and for which there is an established market, except with respect to dealers or traders in commodities. (Reg § 1.965-1(f)(13)(i)(A), Reg § 1.965-1(f)(13)(ii)).
In addition, the final regs exclude forward contracts and short positions with respect to such commodities from the definition of derivative financial instrument to the extent that they could have been identified as a hedging transaction with respect to such commodities. (Reg § 1.965-1(f)(18)(iii), Reg § 1.965-1(f)(18)(v))
IRS has determined that it is appropriate to permit bona fide hedging transactions that are aggregate hedging transactions to be treated as cash-equivalent asset hedging transactions to the extent that the risks managed by the aggregate hedging transaction relate to cash-equivalent hedging transactions. Accordingly, the final regs provide that an aggregate hedging transaction may be treated as a cash-equivalent asset hedging transaction and allocate the value of an aggregate hedging transaction between cash-equivalent hedging transactions and other assets, if any, being hedged. (Reg § 1.965-1(f)(14)(ii))
Prop Reg § 1.965-1(f)(30)(i) provided that a Code Sec. 958(a) U.S. shareholder’s pro rata share of the Code Sec. 965(a) earnings amount of a DFIC is the portion of the Code Sec. 965(a) earnings amount that would be treated as distributed to the Code Sec. 958(a) U.S. shareholder under Code Sec. 951(a)(2)(A) and Reg § 1.951-1(e), determined as of the last day of the inclusion year of the DFIC. IRS has determined that this definition is inconsistent with the statutory language of Code Sec. 951 and Code Sec. 965 in the case in which a specified foreign corporation, whether it is or is not a CFC, ceases to be a specified foreign corporation during its inclusion year. Accordingly, the definitions of “pro rata share” and “section 958(a) U.S. shareholder inclusion year” are revised in the final regs. (Reg § 1.965-1(f)(30), Reg § 1.965-1(f)(34))
IRS has determined that a specified E&P deficit should be allocated to shareholders of an E&P deficit corporation’s preferred stock in cases involving common stock with no liquidation value. Accordingly, the final regs provide that any amount of a specified E&P deficit that would otherwise be allocated in a hypothetical distribution to a class of common stock that has no liquidation value is instead allocated to the most junior class of equity with a positive liquidation value to the extent of the liquidation value. (Reg § 1.965-1(f)(30)(ii)(A))
The final regs also provide that, in cases in which a corporation’s common stock has a liquidation value of zero and there is no class of equity with a liquidation preference relative to the common stock, the specified E&P deficit is allocated among the common stock using any reasonable method consistently applied. (Reg § 1.965-1(f)(30)(ii)(B))
Applicability dates. The final regs retain the applicability dates that were in the proposed regs and, consistent with the applicability date of Code Sec. 965, generally apply beginning the last tax year of a foreign corporation that begins before Jan. 1, 2018, and with respect to a U.S. person, beginning the tax year in which or with which such tax year of the foreign corporation ends.
References: For the treatment of pre-2018 deferred foreign income treated as subpart F income under Code Sec. 965, see FTC 2d/FIN ¶O-2700 et seq.; United States Tax Reporter ¶9654.