IRS has updated Frequently Asked Questions (FAQs) on the transition tax imposed by Code Sec. 965, as added by the Tax Cuts and Jobs Act (TCJA; P.L. 115-97, 12/22/2017). The FAQs provide guidance on logistical issues such as return filing and payment obligations.
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,” for more details, see 2017 Tax Reform: Checkpoint Special Study on foreign income, foreign persons tax changes in the “Tax Cuts and Jobs Act” (12/28/2017). 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 on that income 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 begin 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 to pay tax resulting from Code Sec. 965 when filing their 2017 tax returns. For example, Code Sec. 965 may give rise to a 2017 tax liability for a calendar year U.S. shareholder holding an interest in a calendar year specified foreign corporation.
Previously issued guidance. IRS has previously issued FAQs on the Code Sec. 965 transition tax in mid March (Guidance on return filing and tax payment for transition tax (deemed repatriation) (3/14/2018)), then issued a Notice (Notice 2018-26, 2018-16 IRB) outlining regs that it intends to issue on Code Sec. 965 (IRS outlines regs to be issued on (deemed repatriation) transition tax (4/3/2018)), then released Publication 529 last week explaining how the transition tax is calculated (Publication explains how to calculate (deemed repatriation) transition tax (4/12/2018)).
New guidance. IRS has now updated a number of the previously issued FAQs and released a number of new FAQs, including the following:
…Reporting to partners, shareholders, etc. A domestic partnership, S corporation, or other passthrough entity should attach a statement to its Schedule K-1s, if applicable, that includes the following information for each deferred foreign income corporation for which such passthrough entity has a Code Sec. 965(a) inclusion amount: (i) the partner’s, shareholder’s, or beneficiary’s share of the partnership’s, S corporation’s, or other passthrough entity’s Code Sec. 965(a)inclusion amount, if applicable; (ii) the partner’s, shareholder’s, or beneficiary’s share of the partnership’s, S corporation’s, or other passthrough entity’s deduction under Code Sec. 965(c), if applicable; and (iii) information necessary for a domestic corporate partner, or an individual making an election under Code Sec. 962, to compute its deemed paid foreign tax credits with respect to its share of the partnership’s, S corporation’s, or passthrough entity’s Code Sec. 965(a) inclusion amount, if applicable. (FAQ #9)
…Amended returns. If a person with a net tax liability under Code Sec. 965 has already filed a 2017return, the person should consider filing an amended return based on the information provided in the FAQs and Appendices (below) in order to avoid processing difficulties and erroneous notices being issued, as well as avoid potential interest and penalties if the net tax liability under Code Sec. 965 is not properly reflected. In order to amend a return, a person would file the applicable form and attach amended versions of forms and schedules necessary to follow the instructions in the FAQs, any election statements, and the “IRC 965 Transition Tax Statement” included in Appendix: Q&A3. (FAQ #12)
…Rules for refunds and credits. A taxpayer with 2017 payments, including estimated tax payments, that exceed its 2017 net income tax liability described under Code Sec. 965(h)(6)(A)(ii) (i.e., its net income tax determined without regard to Code Sec. 965) and the first annual installment (due in 2018) pursuant to an election under Code Sec. 965(h) cannot receive a refund of such excess amounts or credit such excess to its 2018 estimated income tax unless and until the amount of payments exceeds the entire unpaid 2017 income tax liability, including all amounts to be paid in installments under Code Sec. 965(h) in subsequent years. Otherwise, the excess will be applied to the next successive annual installment (due in 2019) and subsequent annual installments pursuant to an election under CodeSec. 965(h). (FAQ #14)
Additional reporting guidance. Appendix: Q&A2, which provides information on how amounts included under Code Sec. 965 should be reported on a 2017 return, has been updated to include the following:
…Reporting instructions for individual taxpayers. In general, the net Code Sec. 965 amount (i.e., the amount calculated under Code Sec. 965(a) less the Code Sec. 965(c) deduction) on Page 1, Line 21, Other Income, and to write “SEC 965” on the dotted line to the left of Line 21. The instructions have been updated to clarify that if, however, a Code Sec. 962 election is made, the taxpayer is directed to “consult the Instructions to Form 1040.”
…Reporting instructions for Regulated Investment Companies (RICs). A RIC filing Form 1120 and attaching the “IRC 965 Transition Tax Statement” should Include a net Code Sec. 965 amount (see above) on page 1, Part I, Line 7, “Other Income,” and write “SEC 965” on the dotted line to the left of Line 7. For the foreign tax credit, if applicable, the RIC should enter the relevant Code Sec. 965(a) amount, the relevant Code Sec. 965(c) deduction, the deemed paid foreign taxes with respect to the relevant Code Sec. 965(a) amount, and the foreign taxes disallowed under Code Sec. 965(g) on Form 1118. The taxpayer should include the amount to be paid in installments under Code Sec. 965(h)for years beyond the 2017 tax year, if applicable, on Page 2, Part I, Line 28(i), and should write “965” in the space above Line 28i.
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.
Questions and Answers about Reporting Related to Section 965 on 2017 Tax Returns
