United States: I.R.S. Proposed Regulations Provide Clarity On Code §965 Transition Tax

Last Updated: August 3 2018
Article by Elizabeth V. Zanet and Rusudan Shervashidze

On August 1, 2018, the I.R.S. issued 145 pages of proposed regulations (REG-104226-18) relating to the Code §965 Transition Tax applicable to the 2017 taxable year of U.S. Shareholders holding interests in a deferred foreign income corporation ("D.F.I.C."). A D.F.I.C. is any specified foreign corporation of a U.S. Shareholder that reports positive accumulated post-1986 deferred foreign income as of November 2, 2017, or December 31, 2017.

The proposed regulations modify and provide guidance in addition to three I.R.S. notices issued earlier this year. Here are some highlights.

Tax Rate Computation

  • The tax rate on the amount included in income of a direct or indirect U.S. Shareholder is dependent on the make-up of the balance sheet at several points in time. To the extent that the amount is attributable to the cash position of the specified foreign corporation, the rate is 15.5% for a corporation. The tax rate on amounts in excess of the cash position is 8% for a corporation. The rates are marginally higher for individuals. If a U.S. Shareholder has more than one inclusion year because of variances in the year end of its specified foreign corporations, its aggregate foreign cash position is determined separately for each U.S. Shareholder's inclusion year.
  • The term "cash-equivalent asset" includes derivative financial instruments held by the specified foreign corporation that are not bona fide hedging transactions. Derivative financial instruments include notional principal contracts, options contracts, forward contracts, futures contracts, short positions in securities and commodities, and any similar financial instruments.
  • A domestic partnership may be treated as a foreign partnership for purposes of identifying direct or indirect U.S. Shareholders of specified foreign corporations. This is an expansion on the reference in section 2.13 of Notice 2018-26 to Notice 2010-41, in that all specified foreign corporations are subject to this treatment, not just C.F.C.'s.
  • The Code §965(c) deduction does not reduce the rate of the net investment income tax. For purposes of Code §1411 and Treas. Reg. §1.1411-4(f)(6), a Code §965(c) deduction is not treated as a deduction properly allocable to a corresponding Code §965(a) inclusion.

Foreign Tax Credit

  • The proposed regulations make it clear that neither a deduction or credit is allowed for the applicable percentage of any foreign income taxes attributable to a distribution of Code §965(a) earnings or previously taxed E&P. This rule covers withholding taxes imposed on a U.S. Shareholder by the jurisdiction of residence of the distributing foreign corporation.

Domestic Pass-thru Entities and their Members

  • Solely for purposes of determining whether a foreign corporation is a specified foreign corporation, stock owned, directly or indirectly, by or for a partner will not be considered as being owned by a partnership under applicable attribution rules if the tested partner owns less than 5% of the capital and profits interests.
  • The Transition Tax applies only if a U.S. Shareholder owns, directly or indirectly, stock of a specified foreign corporation. If a domestic pass-thru entity is a U.S. Shareholder of a D.F.I.C., the income inclusion and deduction amount are determined at the level of the domestic pass-thru entity. However, the taxable income and the applicable deduction are computed at the member level.
  • An individual who is not a U.S. Shareholder of a D.F.I.C. is not permitted to make an election under Code §962 with respect to the individual's share of a Code §965(a) inclusion amount of a domestic pass-thru entity.
  • The aggregate amount of the Code §965(a) inclusion of a domestic partnership or S-corporation is treated as a separately stated item of net income solely for purposes of calculating basis under Code §§705(a) and 1367(a)(1) and Treas. Reg. §§1.705-1(a) and 1.1367-1(f). The proposed regulations incorporate the rules concerning basis and AAA adjustments contained in Code §965(f)(2).
  • Since a domestic pass-thru owner will take into account its share of a Code §965(a) inclusion amount and the related Code §965(c) deduction amount, even if it is not itself a U.S. Shareholder, the proposed regulations provide that such owner may make elections under Code §§965(h) (pertaining to the election to pay in installment payments), (m) (regarding special inclusion rules for R.E.I.T.'s), and (n) (pertaining to the election not to apply net operating losses).

Previously Taxed Income

  • A five-step rule is provided for the interaction of Code §§959 and 965.
  • The Code §965(a) inclusion amount must be translated into the functional currency of the D.F.I.C. using the spot rate on December 31, 2017, when determining the amount of previously taxed earnings and profits.

Acceleration Events for Deferred Payments

  • For an underpayment or deficiency assessment with respect to an installment payment, the underpayment or deficiency amount will be prorated among the installments if the additional liability is not due to negligence, intentional disregard, or fraud.
  • The following events are treated as acceleration events:

    • A liquidation or sale of substantially all of the assets of a taxpayer
    • Any exchange or other disposition of substantially all of the assets of a taxpayer
    • Any event that results in a person no longer being a U.S. person
    • A corporation becoming a member of a consolidated group
    • The termination of a consolidated group or the filing of separate returns
  • The "eligible Code §965(h) transferee exception," under which the acceleration rules will not apply, applies only if the eligible Code §965(h) transferee (generally, a U.S. person but not a domestic pass-thru entity) agrees to assume the liability of the transferor for any unpaid installment payments.
  • The transfer agreement must meet all of the requirements in the proposed regulations, including an acknowledgment that the transferor (and any successor) will remain jointly and severally liable for any unpaid installment payments.
  • All members of a consolidated group are treated as a single person for purposes of Code §965(h) (pertaining to the election to pay in installment payments). The determination of whether the sale of assets by a member of a consolidated group to a non-member constitutes an acceleration event takes into account all of the assets of the consolidated group other than stock of another consolidated group member.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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