By Friedemann Thomma & Lauren Keller, Venable LLP
The IRS and Treasury on August 1 released comprehensive proposed regulations on the Section 965 deemed repatriation “toll charge” imposed on US persons with foreign earnings accumulated offshore, generally following guidance announced in three prior notices and a revenue procedure.
While the new regulations provide greater certainty on several issues flagged as requiring additional clarity, they do not incorporate many taxpayer suggestions to improve upon the prior guidance. The regulations slightly diverge from the earlier guidance in a few areas, such as the anti-avoidance and the foreign tax credit coordination rules.
Section 965 deemed repatriation rules
The Section 965 transition tax, created by the Tax Cuts and Jobs Act, is intended to implement the US shift from a worldwide tax system to a participation exemption system. This is accomplished by deeming the earnings of specified foreign corporations to be repatriated to their US shareholders, regardless of whether the earnings were actually transferred to the US.
Section 965 provides that, generally, the Subpart F income of a certain US-owned foreign corporations, called deferred foreign income corporations (DFICs), must be increased by the greater of the foreign corporation’s “accumulated post-1986 deferred foreign income” as of two measurement dates, November 2, 2017 or December 31, 2017. “Accumulated post-1986 deferred foreign income” is equal to the foreign corporation’s post-1986 earnings and profits (E&P) less certain items that would otherwise already be subject to US taxation (i.e. income effectively connected to a US trade or business or previously taxed income).
The new transition tax affects US shareholders, who must include their pro rata portion of the deemed subpart F inclusion under Section 951. US shareholders who must include their pro rata share of the transition tax inclusion amount generally include US individuals, partnerships, trusts, estates, or corporations that directly or indirectly own 10% or more of the total vote or value of the foreign corporation.
Under the new law, domestic corporations are effectively taxed on historic earnings held as cash or cash equivalents at 15.5 percent, and other historic earnings are taxed at 8 percent.
Taxpayers may generally elect to pay their transition tax liability in installments over an eight-year period, however, and various other elections are available under the transition tax provisions and the related guidance.
Prior to issuing the proposed regulations, the government released three notices on Section 965, namely, Notice 2018-17, Notice 2018-13, and Notice 2018-16 and a revenue procedure, Rev. Proc. 2018-17. This guidance announced the expected content of the proposed regulations and requested taxpayer feedback.
Section 965 proposed regulations
The new proposed regulations are quite comprehensive. They provide general rules and definitions for the transition tax, as well as technical rules related to adjusting E&P and basis, determining the allowable deduction, the coordination with foreign tax credit provisions, and the treatment of taxpayers that are members of affiliated groups.
They also provide procedural rules regarding payments and the various elections that are available under the transition tax provisions, as well as with respect to a separate provision that allows a US individual to elect to be taxed as a domestic corporation in certain circumstances.
Requests rejected
The proposed regulations were generally not sympathetic to taxpayers’ requests for relief, but given the timing of the timing of their release (i.e. after the due date for the first installment payment of the transition tax liability, and with little time left before taxpayers who requested extensions will be required to file), it was unlikely that the IRS and Treasury would significantly deviate from their previously issued guidance.
For instance, because DFICs that are not CFCs would not generally track their E&P under US tax principles, taxpayers had requested to use an alternative measurement date for determining their post-1986 E&P and cash positions, such as audited financial statements. Treasury and the IRS acknowledged the administrative challenges involved (especially for minority shareholders), but indicated that the challenges were not unique to the transition tax context and declined to provide alternative methods for the determination.
Other comments were rejected where they would present administrative problems to the IRS, such as taxpayers’ request to adopt a facts-and-circumstances approach for determining when a demand loan should be treated as a short-term obligation.
Even where the proposed regulations did not provide relief from the rule’s application, they did clarify some matters of statutory interpretation.
For example, while taxpayers had requested that previously taxed E&P be disregarded in calculating post-1986 E&P, Treasury and IRS pointed out that such an exclusion is not expressly provided for in that definition (whereas it is expressly excluded in the definition of accumulated post-1986 deferred foreign income) and therefore declined to make such an exclusion.
Anti-avoidance rules, other areas addressed
The proposed regulations contain anti-avoidance rules, which slightly diverge from the anti-avoidance rules provided for in a prior notice.
These rules disregard certain transactions for purposes of the transition tax. For example, transactions which were undertaken with a principal purpose of reducing the amount of the transition tax imposed or which involved changes in method of accounting or entity classification elections that were made between November 2, 2017 and December 31, 2017 will be disregarded for purposes of calculating the transition tax.
No de minimis exceptions will be available, and the preamble rejected taxpayers’ requests that the rules not apply if a reduction in transition tax liability would be offset by a tax under a separate Code provision.
Further, although the relevant calculations and procedures can be complicated when a domestic pass-through entity, such as a domestic partnership, is the US shareholder in a DFIC, the proposed regulations generally affirm previous guidance addressing the application of section 965 in the pass-through context.
Other areas where the proposed regulations go beyond the original guidance include items such as:
- Clarification regarding when an underpayment of an installment constitutes an acceleration event;
- Procedures for transferring deferred Section 965 tax liability between taxpayers; and
- Expansion of the rules relating to foreign tax credit issues, including with respect to the treatment of previously taxed income.
The proposed regulations are generally effective beginning the last taxable year of a foreign corporation that begins before January 1, 2018, and, with respect to a US person, beginning the taxable year in which or with which such taxable year of the foreign corporation ends.
Taxpayers who wish to submit further comments should do so within 60 days of the proposed regulations being published in the Federal Register.
–Friedemann Thomma is a partner at Venable LLP and Chair of Venable’s International Tax Practice. He focuses on corporate international tax planning and US taxation of foreign operations.
–Lauren Keller is an international tax associate at Venable LLP.
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