February 26, 2018
The New Transition Tax Applicable to US Shareholders of Foreign Corporations
On December 22, 2017, President Trump signed into law The Tax Cuts and Jobs Act ("TCJA"). The focus of this alert is the new Code §965 tax known as the "transition tax", intended to assist in the conversion of the US international tax system into a "territorial system", which would enhance the US as a place to do business by eliminating, or reducing, US tax for many US corporations receiving repatriation of future profits from foreign subsidiaries. Expressed very simplistically, the result of the new law is to tax many "US Shareholders" of certain foreign corporations on the past earnings accumulated by the foreign corporations, even if the earnings are not distributed.
WHO IS IMPACTED BY THIS NEW "TRANSITION TAX"?
The new "transition tax" potentially applies to "US Shareholders" of "specified foreign corporations".
Definition of Specified Foreign Corporation
For purposes of the transition tax, a specified foreign corporation is:
- Any "controlled foreign corporation"(CFC), or
- Any foreign corporation which has one or more Domestic (US) corporations which are US Shareholders, regardless of whether that foreign corporation is a CFC.
A "passive foreign investment company" (PFIC) that is not a CFC is excluded from the definition of a specified foreign corporation.1
Definition of Controlled Foreign Corporation (CFC)
If over 50% of the combined voting power, or share value, of a non-US corporation is owned by "US Shareholders", the corporation is a CFC.2
Definition of US Shareholder
Under the law prior to the December 2017 legislation3, a "US Shareholder", with respect to a non-US corporation, was defined as any US person (US citizen, US green card holder or resident, or US entity) who owns (or is "considered as owning") 10% or more of the combined voting power of the corporation.4 The expression or is "considered as owning" is dangerous.
A person with indirect or constructive ownership, may be "considered as owning" the corporation. For example, the shares could be considered as owed indirectly if they are owned through a series of other entities, (tiers of ownership). Or, the shares could be owned constructively if they are owned by other family members, or by any other entity the US person owns.
Unfortunately, the December 2017 legislation3 made changes, which broadened the definition of US Shareholder.
A US Shareholder is now defined as any US person who owns ("or is considered as owning") 10% or more of the combined voting power of the corporation, or 10% or more of the total value of shares of all classes of stock of the corporation. This change is effective:
- For distributions made after December 31, 2017,
- To taxable years of foreign corporations beginning after December 31, 2017, and
- For taxable years of US Shareholders with, or within such taxable years.
Also, with respect to the "constructive" ownership of shares, Code §958 (b)(4) was deleted, which will now result in potential so-called "downward" attribution of ownership. For example, stock of a corporation owned by a person that owns 50% or more in value of the stock of another corporation is treated as owned by such other corporation.5 So, if a nonresident alien owns 50% of the value of the stock of US Corp A and also owns the stock of foreign Corp B, then the stock of Corp B may be attributed to Corp A and Corp B may be a CFC.
Thus, many non-US corporations that were not previously CFCs, will now be categorized as CFCs, due to the change in the definition of US Shareholder and also the downward attribution. Therefore, it is important to revisit the status of each non-US corporation, both for taxation purposes and for Form 5471 filing purposes. Note however, in Notice 2018-13, the IRS announced its intention to amend the instructions to Form 5471 to provide relief from filing the Form for US persons that may otherwise be required to file the Form solely due the downward attribution as a result of the Code §958 (b)(4) repeal.6
THE TRANSITION TAX
The effect of the transition tax is to tax the US Shareholder (see definition above) on "deemed income" from the specified foreign corporation (see definition above).
The deemed income (accumulated post-1986 deferred foreign income7) is the US Shareholder's proportionate share of the specified foreign corporation's retained earnings (accumulated earnings and profits in US tax terminology) that have been accumulated (not distributed) since 1986 (i.e. actually the greater of the balance as at November 2, 2017 or December 31, 2017, unless an alternative date is elected pursuant to IRS Notice 2018-13). The amounts must be computed under US tax principles and regulations.8 An exception applies to previously taxed income such as prior Subpart F inclusions, and certain income which was effectively connected with the conduct of a US trade or business and previously taxed in the US.
Special rules apply when there are at least two specified foreign corporations involved, at least one of which has positive retained earnings, and one or more has a deficit in retained earnings.9
When Does the Transition Tax Apply?
The tax year in which the US Shareholder is deemed to receive the income depends on the tax year of the specified foreign corporation.10
For specified foreign corporations with tax years ending on December 31, 2017, a US Shareholder who is an individual must report the income on his/her calendar year 2017 US tax return, which is due April 17, 2018 (subject to potential extensions).
For specified foreign corporations with tax years ending between January and before December 31, 2017, (fiscal year corporations), US Shareholders who are individuals will have until their calendar year 2018 US tax return to report the income. However, Code §898 requires a CFC to adopt the tax year of its majority shareholder. Therefore, if an individual is the majority shareholder, the CFC would normally have a calendar tax year. Many years ago, the IRS issued a Proposed Regulation intended to provide more flexibility, but it was never adopted or withdrawn.11 The IRS has made it clear they do not want the tax years of specified foreign corporations being changed to defer the tax.12
Special rules apply to US Shareholders that are S corporations.
Calculation of the Transition Tax
The deemed income (which will be treated as Subpart F income under Code §951) will be separated into two categories. The law provides a "discount" (referred as the "participation exemption")13 of 55.7% (category 1) and 77.1% (category 2) from the otherwise applicable tax rate. It is not yet entirely clear from the legislation and international tax commentary what the applicable tax rate is in all cases. For a US corporate shareholder of specified foreign corporation with a calendar year-end, the tax rate is 15.5% (category 1) and 8% (category 2).
Category 1: The portion of the retained earnings represented on the books of the specified foreign corporation by cash and "cash equivalents" (e.g. net accounts receivable).
Category 2: The portion of the retained earnings represented on the books of the specified foreign corporation by other property (e.g. fixed assets).
When is the Transition Tax Due?
For specified foreign corporations with a tax year-end of December 31, 2017, the due date to pay the tax for a US Shareholder who is an individual is April 17, 2018, even if the individual lives outside the US. However, the tax can be paid in installments (see below). For specified foreign corporations with a tax year-end other than December 31, 2017, the due date to pay the tax for a US Shareholder who is an individual, is April 15, 2019.
Tax Payment in Installments
If the appropriate election is timely made, the tax on the deemed income can be paid in 8 annual installments. The required payment for the first 5 installments is 8% of the tax. The 6th, 7th and 8th tax payments respectively are 15%, 20%, and 25% of the tax. The election must be made by the due date for the US Shareholder's US tax return.14 The installment payment must be made by due date for the US Shareholder's US tax return without extensions - i.e. April 17, 2018 for individuals who are US Shareholders of CFCs with a December 31, 2017 tax year-end.
Foreign Tax Credits on Deemed Income
Normally, when foreign income of a US individual is subject to foreign tax, the US individual is entitled to offset part or all of the relevant US tax by the foreign tax paid as a foreign tax credit, or to deduct the tax against income. Any unused foreign tax credit can be carried forward 10 years or carried back 1 year. However, since the tax rate on the deemed income is reduced (see "Calculation of Transition Tax" above), the amount of the foreign tax that can be offset against US tax is similarly reduced in accordance with the same percentages (55.7% and 77.1%).15 Any foreign tax which would be disallowed for foreign tax credit purposes is also disallowed as a deduction against income.16 Some commentators believe this so-called "grind down" is not enforceable, or could possibly be overridden by treaty.
For specified foreign corporations with a December 31, 2017 year-end, there is a potential for double tax for US Shareholders who are individuals living outside the US, because in most cases the deemed income in the US will be taxed again in the foreign county when it is distributed in a subsequent tax year. This can perhaps be ameliorated by making a distribution or bonus payment to the US Shareholder in 2018, and filing an amended 2017 US tax return to carry back as a foreign tax credit in 2017, the foreign tax paid in 2018. Of course, in appropriate circumstances, some attempts may be made for the dividend or bonus to occur in 2017.
Since the deemed income is treated as a Subpart F inclusion, the foreign tax credit "look-through" rules of Code §904(d)(3) and Reg. §1.904-5 will apply, and Reg. §1.904-6(a)(1)(iv) may be relevant to determine the "basket" or "category" to which the deemed income and related tax will be assigned for foreign tax credit purposes. Therefore, the "category" would normally be determined based on the nature of the income earned by the specified foreign corporation. However, it may be relevant that the foreign tax on any subsequent dividend or bonus is derived from a different event that the inclusion of the deemed income.
Future Distributions from the Specified Foreign Corporation
When deemed income which has been taxed under this new transition tax is distributed to the US Shareholder, it is not taxed again to the US Shareholder.17 Technically, the US Shareholder's adjusted basis in the shares of the specified foreign corporation is increased because of the deemed income, and then reduced when it is distributed.18
When subsequent (post tax year 2017) earnings of the specified foreign corporation are distributed to a US Shareholder who is an individual (as distinguished from a US Shareholder that is a domestic corporation) the distribution would be taxed under the normal rules for distributions from foreign corporations. If the recipient US Shareholder is a domestic (US) corporation, the foreign source income portion of the distribution is excluded from tax.19
THE NEW GILTI TAX
Unfortunately, another tax law enacted December 22, 2017, levies a new tax "global intangible low-taxed income" (referred to as the GILTI tax) on foreign corporations owned by US persons, which may tend in part to offset the benefits intended by the enactment of the transition tax. More, soon, about GILTI in another International Tax Alert.
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1 IRC §965(e)
2 IRC §957
4 IRC §951(b) prior to January 1, 2018 (prior to the TCJA amendment)
5 IRS Notice 2018-13 and IRC §318(a)(3)
6 IRS Notice 2018-13, Section 5.02
7 IRC §965(d)(2)
8 IRC §965(d)(3)
9 IRC §965(b)(1)
10 IRC §965(a)
11 IRC §898(a), (b), and (c), and Prop. Reg. §1.898-1(c)
12 IRC §965(o) and IRS Revenue Procedure 2018-17
13 IRC §965(c)
14 IRC §965(h)(5)
15 IRC §965(g)(1) and (2)
16 IRC §965(g)(3)
17 IRC §959(a)
18 IRC §961(a)(1) and (2)
19 IRC §245A