AN INTRODUCTION TO CODE §962
Under Code §962, an individual U.S. Shareholder may elect to be treated as a domestic C-corporation for the purpose of computing income tax on its share of Subpart F Income. This special election was enacted in 1962, and Treasury Regulations followed in 1965 and 1976. As a result of certain international provisions of the Tax Cuts and Jobs Act of 2017 ("T.C.J.A.") and the lowering of the corporate income tax rate to 21%, it has recently gained more attention. Specifically, the Code §962 election has garnered importance with respect to the transition tax under Code §965 and the new tax on global intangible low-taxed income ("G.I.L.T.I.") under Code §951A.
The controlled foreign corporation ("C.F.C.") rules impose an anti-deferral regime that requires a U.S. Shareholder to recognize certain income, known as Subpart F Income, in a current tax year. This income inclusion is applicable regardless of whether the C.F.C. made an actual distribution to the U.S. Shareholder during the tax year. Subpart F Income generally includes passive-type investment income. However, other types of income may also be caught. A U.S. Shareholder is a U.S. person who directly, indirectly, or constructively owns 10% or more of a foreign corporation's vote or, beginning January 1, 2018, value. A C.F.C. is a foreign corporation in which more than 50% of the vote or value is owned by one or more U.S. Shareholders.
Code §962 generally allows an individual U.S. Shareholder (including a trust or estate) to elect to be treated as a domestic C-corporation for the purpose of computing the individual's income tax on its share of Subpart F Income. As a result
- the amount will equal the tax imposed under Code §11 (relating to corporations), rather than under Code §1 (relating to individuals), and
- the individual may obtain an indirect foreign tax credit for the foreign taxes paid or accrued by the C.F.C. with respect to the Subpart F Income under Code §960.
The election is beneficial when an individual U.S. Shareholder's graduated income tax rate is higher than the corporate income tax rate. It also allows the taxpayer to obtain a deemed-paid deduction, which otherwise would not be available to an individual.
LOWER TRANSITION TAX RATE
In order to create a level playing field for all earnings accumulated abroad in C.F.C.'s and certain other non-U.S. corporations, the T.C.J.A. imposes a transition tax on post-1986 deferred earnings and profits.
Under Code §965, an individual or corporate U.S. Shareholder must include in taxable income its pro rata share of accumulated post-1986 deferred foreign earnings of a deferred foreign income corporation ("D.F.I.C.") (the "Code §965(a) inclusion"). This amount is included in a U.S. Shareholder's income as Subpart F Income. A D.F.I.C. is a C.F.C. or any foreign corporation with respect to which one or more domestic corporations is a U.S. Shareholder1 with positive earnings and profit that have not been subject to U.S. tax. The calculation of the Code §965(a) inclusion relies upon to the greater of a D.F.I.C.'s post-1986 deferred foreign earnings as of November 2, 2017, or December 31, 2017. Taxpayers may use the earnings as of October 31, 2017, instead of November 2, 2017.
The Code §965(a) inclusion is eligible for a dividends received deduction under Code §965(c) (the "Code §965(c) deduction"). The calculation of the Code §965(c) deduction is based on the highest rate of tax applicable to corporations under Code §11 in the taxable year of the inclusion, even if the U.S. Shareholder is an individual. As a result of the Code §965(c) deduction, transition tax on the Code §965(a) inclusion generally applies at two rates: (i) 15.5% for earnings treated as cash or cash equivalents ("cash position") and (ii) 8% for the balance of the earnings. However, because the calculation is based on the corporate rate, the Code §965(c) deduction would result in a higher tax rate for individuals in the highest tax bracket (for whom the current tax rate at 37%). To mitigate this result, the Code §962 election is expected to be made by many individuals.
It should be noted that the determination of the "cash position" is made based on the balance sheet by reference to cash measurement dates. For calendar year taxpayers, the cash position is the higher of (i) the amount on December 31, 2017, or (ii) the average on December 31, 2016, and December 31, 2015.
In recently issued guidance, the I.R.S. stated that an individual U.S. Shareholder, or an individual investor in a U.S. Shareholder that is a pass-thru entity, can make an election under Code §962 to be subject to the corporate tax rates for the year of the inclusion. 2 In that case, the Code §965(c) deduction will apply to the tax imposed under the corporate income tax rates, rather than the individual income tax rates. As a result, the transition tax rates of 15.5% on the cash position and 8% rate in all other cases will apply.
In the case of a U.S. Shareholder that is a pass-thru entity, the I.R.S. guidance clarifies that the Code §965(a) inclusion and the Code §965(c) deduction are determined at the level of the entity, and the owners of the entity will be subject to tax on their allocable share of the inclusion regardless of whether they are U.S. Shareholders with respect to the foreign corporation. However, the guidance states that regulations will provide that a Code §962 election will be available for individual owners (including trusts and estates) with respect to their share of the income inclusion only if they themselves are U.S. Shareholders with respect to the foreign corporation – meaning only individuals who own directly or indirectly 10% or more of the vote or value in the foreign corporation may make a Code §962 election.
The I.R.S. guidance also provides that the Code §965(c) deduction allowed in determining the taxable income and the tax due as a result of the Code §962 election cannot be used to reduce the individual's tax under Code §1 (i.e., the individual's other taxable income).
Additionally, as with a corporate U.S. Shareholder, an individual U.S. Shareholder that makes an election under Code §962 is eligible for an indirect foreign tax credit attributable to foreign taxes paid or accrued on the C.F.C.'s Code §965(a) inclusion (although the credit is subject to a haircut), 3 which will lower the overall effective tax rate applicable for the Code §965(a) inclusion.
1 Code §965(e)(1).
2 Notice 2018-26, §5.
3 Code §965(g).
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