The recently passed tax act uses the mechanics of subpart F to impose a one-time “toll tax” on the undistributed, non-previously taxed, post -1986 foreign earnings and profits (E&P) of certain U.S.-owned corporations as part of the transition to a new partial territorial tax regime.
This transition from the historical deferral regime to a participation exemption regime for the U.S. recognition of income earned by controlled foreign corporations (CFC) owned by U.S. shareholders generally requires that, for the last taxable year of a foreign corporation beginning before January 1, 2018, all U.S. shareholders of any CFC or other foreign corporation that is at least 10-percent U.S.-owned but not controlled (other than a passive foreign investment corporation, i.e. PFIC) must include in income their pro rata shares of the accumulated post-1986 deferred foreign income that was not previously taxed. In other words, tax may now be due before cash is actually repatriated (due to this new “deemed repatriation” method), and for calendar year taxpayers, the first payment of that tax is due in April of 2018.
Some key points to this one-time repatriation tax:
- A portion of that pro rata share of deferred foreign income is deductible; the amount deductible varies depending upon whether the deferred foreign income is held in the form of cash and cash equivalents or illiquid assets.
- The deduction results in a reduced rate of tax of 15.5 percent for the included deferred foreign income held in liquid cash or cash equivalents and 8 percent for remaining deferred foreign income.
- A corresponding portion of the credit for foreign taxes is disallowed, thus limiting the credit to the taxable portion of the included income.
- The increased tax liability generally may be paid over an eight-year period. For certain U.S. shareholders filing their tax returns on a calendar year basis, this could mean the first installment payment of this tax could be due on April 16, 2018, when the applicable U.S. shareholder tax return is filed or extended.
- Permits a U.S. shareholder to elect to preserve net operating losses (NOLs) and opt out of utilizing such NOLs to offset the mandatory inclusion.
Subpart F inclusion of deferred foreign income
The mechanism for requiring an inclusion of pre-effective-date foreign earnings is subpart F. The provision provides that in the last taxable year of a deferred foreign income corporation (DFIC) that begins before January 1, 2018, which is that foreign corporation’s last taxable year before December 31, 2017, the subpart F income of the foreign corporation is increased by the greater of the accumulated post-1986 deferred foreign income of the corporation, determined as of November 2, 2017, or as of December 31, 2017 (“measurement date”), whichever date reflects the greatest amount of deferred E&P. The amount so determined is includible in gross income under section 951 (hereinafter, “the section 951 inclusion”).
Who are U.S. Shareholders of SFCs affected by this Repatriation Tax?
Specifically, under this new law, any U.S. shareholder of a specified foreign corporation (“SFC”) must include in its income the pro rata share of the accumulated post-1986 deferred income of the deferred foreign income of the corporation for the last taxable year beginning before January 1, 2018. While this one time dividend repatriation tax was meant to accelerate all offshore earnings of multinational corporations, it seems Congress has constructed the statute so that the tax applies to individuals also. This tax will apply to all U.S. Shareholders who own a 10% or more voting interest in SFCs. Such shareholder may include individuals, LLCs, partnerships and corporations. SFCs include CFCs and what is known as 10/50 companies(1), but not passive foreign investment companies (PFICs) that are not CFCs. This is in contrast to the participation exemption, whereby future dividends from SFCs will be exempt from U.S. income tax, and the shift to a territorial tax regime, which is only relevant for C corporations.
What is accumulated post-1986 deferred foreign income?
Accumulated post-1986 deferred foreign income of an SFC that is the subject of the mandatory inclusion under this provision is the greater of the accumulated post-1986 deferred foreign income determined as of November 2, 2017 (the date of introduction of the bill) or as of December 31, 2017. The includible portion of the accumulated post-1986 deferred foreign income is all post-1986 earnings and profits that (1) are not attributable to income that is effectively connected with the conduct of a trade or business in the United States and thus subject to current U.S. income tax, or (2) when distributed, are not excludible from the gross income of a U.S. shareholder as previously taxed income under section 959.
The potential pool of includible earnings includes all undistributed foreign earnings accumulated in taxable years beginning after 1986, computed in accordance with sections 964(a) and 986, taking into account only periods when the foreign corporation was a specified corporation. The pool of post-1986 foreign earnings and profits is not reduced by distributions during the taxable year to which section 965 applies.
Reductions of amounts included in income are allowed for U.S. shareholder of foreign corporations with deficits in earnings and profits. The pool of post-1986 earnings and profits taken into consideration in computing the section 951 inclusion required of a U.S. shareholder under this transition rule generally is reduced by foreign earnings and profits deficits that are properly allocated to that person. The U.S. shareholder must determine its aggregate E&P deficit based on its interest in each specified foreign corporation with a deficit in post-1986 foreign earnings and profits as of the measurement date (“E&P deficit foreign corporation”).
Deductions from section 951 inclusion
Instead of prescribing a fixed percentage of the section 951 inclusion resulting from section 965 for which a partial dividends-received deduction is permitted, the new tax law adopts the rate equivalent percentage method. As a result, the total deduction from the amount of the section 951 inclusion is the amount necessary to result in a 15.5-percent rate of tax on accumulated post-1986 foreign earnings held in the form of cash or cash equivalents, and 8-percent rate of tax on all other earnings. The calculation is based on the highest rate of tax applicable to corporations in the taxable year of inclusion, even if the U.S. shareholder is an individual.
The use of rate equivalent percentages is intended to ensure that the rates of tax imposed on the deferred foreign income is similar for all U.S. shareholders, regardless of the year in which section 965 gives rise to an income inclusion. Individual U.S. shareholders, and the investors in U.S. shareholders that are pass-through entities generally can elect application of corporate rates for the year of inclusion. In addition, the increase in income that is not taxed by reason of the partial dividends-received deduction allowed under this provision is treated as income exempt from tax for purposes of determining the basis in an interest in a partnership or subchapter S corporation, but not as income exempt from tax for purposes of determining the accumulated adjustments account of a subchapter S corporation. IRS guidance will be forthcoming that provides for similar treatment under section 986(c), such that any gain or loss recognized thereunder with respect to distributions of earnings previously taxed (or treated as previously taxed) by reason of this new Section 965(a) will be diminished proportionately to the diminution of the net taxable income resulting from section 965(a) by reason of the deduction allowed under section 965(c). In other words, any gain or loss from foreign exchange differences between the time this income is included in a shareholder’s tax return and the time that the cash is remitted will have to be adjusted accordingly by this deduction.
Aggregate cash position
The aggregate cash position of a U.S. shareholder is the average of the sum of the shareholder’s pro rata shares of the cash positions of each specified foreign corporation in which that shareholder is a U.S. shareholder on each of three dates: Date of introduction, (the introduction of tax legislation) November 2, 2017, and the last day of the two most recent taxable years ending before the date of introduction. Appropriate adjustments are made if a specified foreign corporation is not in existence on one or more of those dates. By using a three-year average as the aggregate cash position for a U.S. shareholder, the effect of unusual or anomalous transactions is muted.
With respect to any U.S. shareholder, the aggregate foreign cash position is the greater of:
- the aggregate of the U.S. shareholder’s pro rata share of the cash position of each specified foreign corporation of the U.S. shareholder determined as of the close of the last tax year of the specified foreign corporation that begins before January 1, 2018; or
- one half of the sum of:
- the aggregate described in item (1), above, determined as of the close of the last tax year of each specified foreign corporation that ends before November 2, 2017, plus
- the aggregate described in item (1), above, determined as of the close of the tax year of each specified foreign corporation that precedes the tax year referred to in item (2).
In other words, the aggregate foreign cash position is the greater of the aggregate cash position as of the last day of the last tax year beginning before January 1, 2018, and the average aggregate cash position as of the last day of each of the last two years ending before the date of introduction (November 2, 2017).
The cash position of any specified foreign corporation is the sum of:
- cash held by the foreign corporation;
- the net accounts receivable of the foreign corporation (the excess (if any) of the corporation’s accounts receivable over its accounts payable), plus
- the fair market value of the following assets held by the corporation:
- Actively traded personal property for which there is an established financial market.
- Commercial paper, certificates of deposit, the securities of the Federal government and of any State or foreign government.
- Any foreign currency.
- Any obligation with a term of less than one year.
- Any asset that the Secretary identifies as being economically equivalent to the assets described above.
To avoid double counting, cash assets described in items (2), (3)(a) and (3)(d), above, are not taken into account in determining the aggregate foreign cash position to the extent that the U.S. shareholder demonstrates to the satisfaction of the Secretary that the amount is taken into account by the shareholder with respect to another specified foreign corporation. Thus, cash holdings of a specified foreign corporation in the form of publicly traded stock may be excluded to the extent that a U.S. shareholder can demonstrate that the value of the stock was taken into account as cash or cash equivalent by another specified foreign corporation of the U.S. shareholder.
Cash positions of certain noncorporate entities
A noncorporate entity is treated as a specified foreign corporation of a U.S. shareholder for purposes of determining the shareholder’s aggregate foreign cash position if (i) any interest in the entity is held by a specified foreign corporation of the U.S. shareholder (determined after application of this rule), and (ii) the entity would be a specified foreign corporation of the shareholder if the entity were a foreign corporation. So if a U.S. shareholder owns a five-percent interest in a partnership, the balance of which is held by specified foreign corporations of the U.S. shareholder, the partnership is treated as a specified foreign corporation with respect to the U.S. shareholder, and the cash or cash equivalents held by the partnership are includible in the aggregate cash position of the U.S. shareholder on a look-through basis.
Foreign tax credits reduced
No foreign tax credit or deduction is allowed for a portion (referred to as an applicable percentage) of any foreign income taxes paid or accrued (or deemed paid or accrued) with respect to any mandatory inclusion amount for which a deduction is allowed in the above rules. The disallowed portion of the foreign tax credit is 55.7% of the foreign taxes paid attributable to the portion of the inclusion amount related to the U.S. shareholder’s aggregate foreign cash position, plus 77.1% of the foreign taxes paid attributable to the remaining portion of the mandatory inclusion amount. Other foreign tax credits used by a taxpayer against liability resulting from the deemed inclusion amount apply in full. The end result is that the foreign tax credit is limited to the taxable portion of the mandatory inclusion amount.
Under the coordination rule, the foreign taxes treated as paid or accrued by a domestic corporation as a result of the inclusion are limited to those taxes in proportion to the taxable portion of the section 965 inclusion. The gross-up amount equals the total foreign income taxes multiplied by the fraction, numerator of which is taxable portion of the increased subpart F income under this provision and the denominator of which is the total increase in subpart F income under this provision.
A U.S. shareholder may elect to pay the net tax liability resulting from the mandatory inclusion of pre-effective-date undistributed CFC earnings in eight installments. The payments for each of the first five years equal 8 percent of the net tax liability, the sixth installment equals 15 percent of the net tax liability, increasing to 20 percent for the seventh installment and the remaining balance of 25 percent in the eighth year.
Net tax liability: The net tax liability that may be paid in installments is the excess of the U.S. shareholder’s net income tax for the taxable year in which the pre-effective-date undistributed CFC earnings are included in income over the taxpayer’s net income tax for that year determined without regard to the inclusion. Net income tax means net income tax as defined for purposes of the general business credit, but reduced by the amount of that credit.
Making the election: An election to pay tax in installments must be made by the due date for the tax return for the taxable year in which the pre-effective-date undistributed CFC earnings are included in income. The IRS will be issuing regulations to prescribe the manner of making the election.
Making the payment of tax: The first installment must be paid on the due date (determined without regard to extensions) for the tax return for the taxable year of the income inclusion. Succeeding installments must be paid annually no later than the due dates (without extensions) for the income tax return of each succeeding year.
Proration of deficiency to installments: If a deficiency is later determined with respect to the net tax liability, the additional tax due may be prorated among all installment payments in most circumstances. The portions of the deficiency prorated to an installment that was due before the deficiency was assessed must be paid upon notice and demand. The portion prorated to any remaining installment is payable with the timely payment of that installment payment, unless the deficiency is attributable to negligence, intentional disregard of rules or regulations, or fraud with intent to evade tax, in which case the entire deficiency is payable upon notice and demand.
The timely payment of an installment does not incur interest. If a deficiency is determined that is attributable to an understatement of the net tax liability due under this provision, the deficiency is payable with underpayment interest for the period beginning on the date on which the net tax liability would have been due, without regard to an election to pay in installments, and ending with the payment of the deficiency. Furthermore, interest will apply to any amount of deficiency prorated to a remaining installment, but not on the original installment amount.
Acceleration rule: The provision also includes an acceleration rule. If (1) there is a failure to pay timely any required installment, (2) there is a liquidation or sale of substantially all of the U.S. shareholder’s assets (including in a bankruptcy case), (3) the U.S. shareholder ceases business, or (4) another similar circumstance arises, the unpaid portion of all remaining installments is due on the date of the event (or, in a title 11 case or similar proceeding, the day before the petition is filed).
Special rule for S corporations
A special rule permits deferral of the transition net tax liability BY shareholders of a U.S. S corporation that in turn owns a CFC. The S corporation is required to report on its income tax return the amount includible in gross income by reason of this provision, as well as the amount of deduction that would be allowable, and provide a copy of such information to its shareholders. Any shareholder of the S corporation may elect to defer his portion of the net tax liability at transition to the participation exemption system until the shareholder’s taxable year in which a triggering event occurs. The election to defer the tax is due no later than the due date for the return of the S corporation for its last taxable year that begins before January 1, 2018.
Triggering events: Three types of events may trigger an end to deferral of the net tax liability:
- The first type of triggering event is a change in the status of the corporation as an S corporation.
- The second category includes liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, including reorganization in bankruptcy.
- The third type of triggering event is a transfer of shares of stock in the S corporation by the electing taxpayer, whether by sale, death or otherwise, unless the transferee of the stock agrees with the IRS to be liable for net tax liability in the same manner as the transferor. Partial transfers trigger the end of deferral only with respect to the portion of tax properly allocable to the portion of stock sold.
Joint and several liability; extension of limitation on collection: If a shareholder of an S corporation has elected deferral under the special rule for S corporation shareholders and a triggering event occurs, the S corporation and the electing shareholder are jointly and severally liable for any net tax liability and related interest or penalties. The period within which the IRS may collect such liability does not begin before the date of an event that triggers the end of the deferral.
Annual reporting of net tax liability: If an election to defer payment of the net tax liability is in effect for a shareholder, that shareholder must report the amount of the deferred net tax liability on each income tax return due during the period that the election is in effect. Failure to include that information with each income tax return will result in a penalty equal to five-percent of the amount that should have been reported.
Election to pay deferred liability in installments: After a triggering event occurs, a shareholder in the S corporation may elect to pay the net tax liability in eight equal installments, subject to rules similar to those generally applicable absent deferral. Whether a shareholder may elect to pay in installments depends upon the type of event that triggered the end of deferral. If the triggering event is a liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, the installment payment election is not available. Instead, the entire net tax liability is due upon notice and demand. The installment election is due with the timely return for the year in which the triggering event occurs. The first installment payment is required by the due date of the same return, determined without regard to extensions of time to file.
Effective Date: This new one-time deemed dividend repatriation tax is effective for the last taxable year of a foreign corporation that begins before January 1, 2018, and with respect to U.S. shareholders, for the taxable years in which or with which such taxable years of the foreign corporations end.
If you would like to discuss these matters further, please call Stuart Lyons or your usual BNN professional at 1.800.244.7444.
(1) 10/50 companies must have at least one U.S. shareholder that is a domestic corporation in order for the repatriation tax to be applicable.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.