The Section 965 Transition Tax And IRS Audits
Section 965 audits are on the rise. Taxpayers under section 965 transition tax audits often face significant potential liability exposure. The IRS previously announced an active “campaign” specifically targeting unpaid section 965 transition tax liability resulting from amendments to section 965 under the Tax Cuts & Jobs Act. For taxpayers with ownership in foreign corporations, that could mean increased exposure to an IRS audit.
On December 22, 2017, Congress amended the Internal Revenue Code (“IRC”) Section 965 through the Tax Cuts & Jobs Act (“TCJA”). As amended, Section 965 required that certain taxpayers include a “Section 965 inclusion” in income as part and parcel of the transition to a participation-exemption tax system (or, at least, a quasi participation-exemption system). The Section 965 inclusion is an amount based on the accumulated post-1986 deferred foreign income of certain foreign corporations directly or indirectly owned by the taxpayer. Notably, taxpayers can have Section 965 inclusions due to ownership of deferred foreign income corporations (“DFICs”) indirectly held through pass-through entities that are themselves U.S. shareholders of DFICs.
Section 965 generally requires that “United States shareholders,” as defined in section 951(b), pay a “transition tax” on the untaxed foreign earnings of certain specified foreign corporations. In effect, Section 965 treats those earning as if they had been repatriated to the United States.
Generally, a “specified foreign corporation” is defined as either a controlled foreign corporation, (“CFC”) (as defined under IRC 957) or a foreign corporation (other than a passive foreign investment company, as defined under IRC 1297, that is not also a CFC) that has a United States shareholder that is a domestic corporation.
The Code allows certain taxpayers to make important elections with respect to Section 965. Those elections include:
- An election to pay the section 965 net tax liability over eight years.
- An election by S corporation shareholders to defer payment of the section 965 net tax liability with respect to such S corporation until a triggering event.
- An election by real estate investments trusts to take both section 965(a) inclusions and the corresponding section 965(c) deductions into account over eight years.
- An election not to apply a net operating loss.
- An election to use an alternative method to calculate post-1986 earnings and profits (post 1986 E&P).
- An election to use basis adjustments under Treas. Reg. 1.965-2(f).
Who is Subject to IRC Section 965?
A U.S. shareholder (as defined in IRC 951(b)) who owns the stock of an SFC, directly or indirectly, within the meaning of section 958(a) may be subject to Section 965. A U.S. shareholder includes a U.S. person who owns 10% of the voting power of a foreign corporation. If a domestic pass-through entity is a section 958(a) U.S. shareholder of an SFC, the domestic pass-through owners are subject to section 965.
A Specified Foreign Corporation is a CFC, or “a foreign corporation” (other than a passive foreign investment company (“PFIC”)) with a corporate U.S. shareholder. A CFC is a foreign corporation that is more than 50% owned— directly, indirectly, or constructively—by vote or value, by one or more U.S. shareholders at any time during the taxable year of the corporation.
What is the Base Upon Which Section 965 Tax is Calculated?
The section 965 Transition tax is applied with respect to the U.S. shareholder’s pro-rata share of accumulated post-1986 Deferred Foreign Income (“DFI”) less EPDFC.
What is a deferred foreign income corporation (“DFIC”)? A DFIC is an SFC that had accumulated post-1986 deferred foreign income greater than zero as of either 11/2/17 or 12/31/17 (each, an “E&P measurement date”), except generally to the extent the E&P constitute effectively connected income (“ECI”) or previously taxed income (“PTI”).
What is an E&P deficit foreign corporation (“EPDFC”)? An EPDFC is, with respect to a section 958(a) U.S. shareholder, an SFC if, as of 11/2/17, the SFC had a deficit in post-1986 earnings and profits, the corporation was an SFC, and the shareholder was a U.S. shareholder of the corporation.
Year of Inclusion and Timing of IRC 965 Inclusion
Section 965(a) increases the “subpart F” income of a DFIC for its last taxable year beginning before 1/1/18 by the greater of its DFI as of each E&P measurement date (11/2/17 or 12/31/17).
A section 958(a) U.S. shareholder of a DFIC must include in its income its pro rata share of the DFI of the DFIC for the last taxable year of the DFIC beginning before 1/1/18 (“inclusion year”).
The amount required to be included is reported on the shareholder’s return for the taxable year in which or with which the last day of the DFIC’s taxable year on which it is an SFC occurs (“section 958(a) U.S. shareholder inclusion year”).
The Earnings Amount
A person who is a U.S. shareholder of a DFIC may be required to report information relevant to section 965 and any potential section 965 liability. In addition, other persons may be required to report section 965 information, including:
- a direct or indirect partner in a domestic partnership,
- a shareholder in an S corporation, or
- an owner or beneficiary of another domestic passthrough entity that is a U.S. shareholder of a DFIC.
Taxpayers may have unexpected inclusions under section 951(a) and section 965 because of their ownership of a DFIC through a pass-through entity that is itself a U.S. shareholder of DFICs.
If a taxpayer has a section 965 inclusion via section 951(a), the amount increases the subpart F income of the DFIC in the last taxable year starting before 1/1/18.
Allocation of Deficits
If a U.S. shareholder owns one or more DFIC and at least one EPDFC, the section 965(a) earnings amount that would otherwise be included in the U.S. shareholder’s subpart F income is reduced by the amount of such shareholder’s aggregate foreign E&P deficit that is allocated to such DFIC. The resulting amount is the section 965(a) inclusion amount.
The taxpayers aggregate foreign E&P deficit is allocated among the U.S. shareholder’s DFICs in an amount that bears the same proportion to such aggregate as such U.S. shareholder’s pro rata share of the section 965(a) earnings amount of each such DFIC bears to the aggregate of such U.S. shareholder’s pro rata share of the section 965(a) earnings amount of all DFICs of such U.S. shareholder.
Section 965(c) Deduction
A U.S. shareholder with a section 965(a) inclusion is entitled to a deduction. The deduction results in the inclusion being taxed at an effective rate of 15.5% rate to the extent E & P is attributable to cash and at 8% otherwise.
Section 965 Elections
Section 965 allows for several potential elections. The elections under section 965 are limited to taxpayers with a net tax liability under section 965 (in the case of IRC 965(h)), taxpayers that are shareholders of S corporations and have a net tax liability under section 965 (in the case of IRC section 965(i)), taxpayers that are REITs (in the case of IRC 965(m)), or taxpayers with an NOL (in the case of IRC 965(n)). A domestic partnership or an S corporation that is a U.S. shareholder of a DFIC may not make any of the elections under section 965 of the Code.
The elections under IRC 965 include:
- IRC 965(h): taxpayers with a net tax liability under IRC 965.
- IRC 965(i): taxpayers that are shareholders of S corporations and have a net tax liability under IRC 965.
- IRC 965(m): taxpayers that are REITs.
- IRC 965(n): taxpayers with an NOL.
- Election to use alternative method to compute post-1986 E&P.
- Election to use basis adjustments under Treas. Reg. 1.965-2(f).
The section 965 election was required to be made by the due date (including extensions) for filing the return for the relevant year. Note, however, that the first installment payment was nonetheless due by the due date (without extensions) for filing the return for the relevant year.