New IRC Section 965 Guidance on Foreign Earnings and Profits – Crucial to 2017 Tax Returns
Berdon Tax Team
04.03.2018 | Client Alert
The IRS recently issued, in Q&A format, compliance guidance for the new Internal Revenue Code Section 965 and the deemed repatriation of certain foreign accumulated earnings and profits. This guidance (FAQ Guidance) can be found on the IRS website1, and contains various resources and statement form templates to reference when complying with section 965 and making various elections. It also provides for certain naming conventions that must be followed when filing statements in PDF format.
The following contains additional details about this provision, which we examined earlier this year.
Added by the Tax Cuts and Jobs Act (TCJA), new Code Section 965 imposes a tax (a “Transition Tax”) on certain previously undistributed and un-taxed (by the U.S.) foreign earnings of certain specified foreign corporations (each a “Deferred Foreign Income Corporation” or “DFIC”). These specified foreign corporations include controlled foreign corporations (“CFCs”), as well as foreign corporations with one or more U.S. corporate shareholder (United States Shareholders2). Thus, the Transition Tax generally applies to U.S. persons owning 10% or more – by vote or value – of either CFCs or foreign corporations with certain domestic corporations as shareholders.
The Transition Tax is based on the inclusion of the specified foreign corporation’s undistributed, post-1986 earnings and profits (“post-1986 E&P”) in the United States shareholder’s subpart F income.3 A participation exemption deduction effectively reduces the rate of tax imposed on those earnings; the deduction calculation depends on the foreign corporation’s asset composition, with foreign earnings reflected in cash and cash equivalents subject to a higher, though still beneficial, rate than earnings invested in non-cash assets (15.5% versus 8%).
The Transition Tax is payable by the United States Shareholder, or in the case of United States Shareholders that are pass-through entities, by the partners, shareholders, or beneficiaries. A partial foreign tax credit (“FTC”) is available to certain taxpayers to offset the computed liability4 and net operating losses (“NOLs”) can, unless the taxpayer elects otherwise as discussed below, reduce the inclusion. Note that for calendar year foreign corporations, the 965 inclusion and associated tax are, along with the various elections described below, items reportable (and payable) on 2017 returns.
Section 965 Elections
Section 965 also provides for several elections, each of which, will require an election statement in the format provided in the FAQ Guidance. These elections include:
- An election to pay the Transition Tax in installments over an eight-year period, detailed as follows:
|Percent of Tax Due||Year(s)|
|8%||1 - 5|
- An election for S corporation United States shareholders to defer the Transition Tax until a specified “triggering event,” such as the termination of S corporation status, the liquidation or sale of substantially all the S corporation’s assets, and the transfer of any share of stock in the S corporation, including transfers on death;
- An election not to apply NOLs in the calculation of the Transition Tax;5 and
- A special election for REITs relating to the timing of the inclusion calculated under section 965 for REIT testing purposes.
An additional election is provided in IRS guidance. In one of two previous notices related to Section 965 issued by Treasury and the IRS, an alternative method for calculating post-1986 E&P is provided. The use of this Alternative Method is elective and if the election is made, will require an election statement in the format outlined in the FAQ Guidance discussed below.
IRS FAQ Guidance
The FAQ Guidance and its appendices provide guidance on various reporting and record-keeping matters related to Section 965, which includes:
- Those subject to reporting amounts under Section 965, including corporate or individual United States shareholders in a DFIC as well as taxpayers that are partners or shareholders in partnerships or S corporations that are United States shareholders in a DFIC (see Q&A #1);
- While taxpayers subject to the Transition Tax may elect to pay the Transition Tax in installments, the FAQ Guidance confirms that the first installment is due on the due date for the relevant Section 965 payor’s return, without extensions (see Q&A #6; Q&A #10). For calendar year corporations and individuals, this means April 17, 2018. The various elections under Section 965 may, however, not be due until the extended due date for the relevant return (see Q&A #6);
- The FAQ Guidance provides several tables in the Appendix: Q&A #2 with detailed and very specific instructions on how to reflect the section 965 Transition Tax and related items on various 2017 tax forms, including forms 1040, 1120S, 1065, 1041, 1120, and 1120-REIT;
- In Q&A #7, the FAQ Guidance provides links to various election statements and instructions on how to file those statements (discussed below);
- The FAQ Guidance, as part of Q&A #3, provides a form for a required “IRC 965 Transition Tax Statement” that provides certain information related to the Transition Tax calculation. This statement must be signed under penalties of perjury and, if electronically filed, in pdf format with a specified filename. To support the required IRC 965 Transition Tax Statement, adequate records must be maintained supporting the various amounts used to calculate the Transition Tax (see Q&A #3);
- According to the FAQ Guidance at Q&A #9, certain information must be provided on a statement attached to a pass-through entity’s schedule K-1, including (1) the partner, shareholder or beneficiary’s share of the Section 965 inclusion and related deduction and (2) certain information related to deemed paid foreign tax credits;
- The FAQ Guidance provides payment mechanics and instructions (see Q&A #10) and specifically requires the Section 965 Transition Tax payment be made separately, whether by check or wire transfer (specific wire transfer instructions are provided in the FAQ Guidance);
- Electronically-filed 1040s should be filed on or after April 2, 2018 (see Q&A #11). Paper-filed 1040s can be filed at any time;
- For returns that have already been filed, the FAQ Guidance suggests the filing of an amended return consistent with the FAQ Guidance (see Q&A #12); and
- Required Form 5471 – the FAQ Guidance requires the filing of a form 5471 with respect to foreign corporations triggering a Section 965 inclusion regardless of whether the specified foreign corporation is a CFC (see Q&A #8).
Election Form Statements
In addition to the IRC 965 Transition Tax Statement Form, the FAQ Guidance provides links to various form statements for use when making various elections with respect to section 965 (see Q&A #7). Statement forms are provided for the following elections:
- Section 965(h)(1)’s election to pay the Transition Tax in installments;
- Section 965(i)’s S-corporation election to defer the Transition Tax payment until the occurrence of a specified “triggering event”;
- Section 965(n)’s election to not apply NOLs in the calculation of the Transition Tax;
- Notice 2018-13’s election to use an alternative method for calculating post-1986 E&P; and
- Section 965(m)(1)’s election for REITs to defer the timing of the section 965 income inclusions.
The following is also important to note:
- Q&A #7 also provides naming conventions to be used when filing the statements electronically.
- Elections are generally made by the United States shareholders, or in the case of pass-through entities that are United States shareholders, by the partners or S corporation shareholders.
The Guidance cautions that failing to follow its instructions as well as its suggested forms and formats may result in erroneous notices as well as processing difficulties and delays.
More Client Alerts will be distributed as additional guidance is issued by Treasury and the IRS.
For any questions on this Alert, please contact Marc Ausfresser at 212.331.7639 | firstname.lastname@example.org, or Lisa Goldman at 212.699.8808 | email@example.com, or contact your Berdon tax advisor.
1 See https://www.irs.gov/newsroom/questions-and-answers-about-reporting-related-to-section-965-on-2017-tax-returns
2 A United States Shareholder is generally a U.S. person that owns, either directly, indirectly through certain foreign entities, or constructively, ten percent of either the combined voting power or total value of a foreign corporation.
3 For calendar year foreign corporations, the inclusion is generally based on the higher of post-1986 undistributed E&P as of two dates: November 2, 2017 and December 31, 2017. Section 965 provides for the netting of certain E&P deficits (in other foreign corporations) against the inclusion amount.
4 The FTC with respect to the Transition Tax is available solely to domestic corporations and individuals electing to be treated as corporations for certain tax purposes.
5 Taxpayers may elect to preserve their NOLs against higher-taxed income given the beneficial tax rates applicable to the Transition Tax.