On August 1, 2018, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued proposed regulations, which were published in the Federal Register on August 9, 2018 (Proposed Regulations), addressing the amendment and application of section 965 of the Internal Revenue Code of 1986, as amended (the Code), which was amended by Public Law 115-97, commonly known as the Tax Cuts and Jobs Act (the Act). On August 2, 2018, the IRS issued Program Manager Technical Advice 2018-016 (PMTA 2018-016) regarding the treatment of overpayments for section 965 installment payments under section 965(h). Section 965 generally imposes a transition tax on a US shareholder’s pro rata share of the accumulated earnings and profits (E&P) of a “specified foreign corporation.” Notably, the Proposed Regulations include:
- Detailed rules for calculating the amount of tax liability under section 965, including the related deductions and any foreign tax credits (FTCs) with respect to such inclusions. The importance of these calculations cannot be overstated, given that this will be the last opportunity for the US to tax the undistributed post-1986 E&P of specified foreign corporations as the Act shifts the US toward a territorial system. Taxpayers’ section 965 calculations are likely to be closely scrutinized by the IRS.
- Rules that generally do not deviate substantially from prior IRS guidance and provide some additional clarification. The IRS issued several Notices and other guidance following the amendment of section 965 by the Act (see Notice 2018-26, Notice 2018-13, Notice 2018-07, Revenue Procedure 2018-17, and a list of “frequently asked questions” (FAQs) (collectively, Prior Guidance)).
- Specific requirements for making elections regarding the application of section 965. Section 965 elections generally are required to be made with the taxpayer’s 2017 federal income tax return for calendar-year taxpayers (or by October 9, 2018, for taxpayers that did not file for extensions). Taxpayers generally are not entitled to relief for late filing of such elections.
The guidance and clarifications in the Proposed Regulations address all aspects of the application of section 965, including the determination of the amount of E&P subject to the transition tax, the calculation of the amount of the tax, the FTC implications of the inclusions under section 965, the election to defer payment of any resulting tax liability, and the treatment of previously taxed E&P arising from the application of section 965.
The Proposed Regulations will apply beginning with the last taxable year of a foreign corporation that begins before January 1, 2018, and, with respect to a United States person, beginning with the taxable year in which or with which such taxable year of the foreign corporation ends. However, Prop. Treas. Reg. § 1.965-4 (disregard of certain transactions for purposes of section 965) applies to prior years, as well.
The discussion below highlights some of the key takeaways from the Proposed Regulations.
Determination of Net Accumulated E&P - Section 965 imposes a one-time transition tax on a United States shareholder with respect to its investment in controlled foreign corporations (CFCs) and certain other foreign corporations (collectively, specified foreign corporations or SFCs). The tax is generally imposed on the net aggregate amount of the United States shareholder’s pro rata share of the previously untaxed foreign E&P of such SFCs. Previously untaxed foreign E&P subject to section 965 is the greater of such amount determined as of November 2, 2017, or December 31, 2017. Key takeaways with respect to the determination of accumulated E&P subject to section 965 include:
- Alternative method for calculation of E&P of SFCs. As indicated by the IRS in Notice 2018-13, the Proposed Regulations provide an election for SFCs to use an alternative method to calculate E&P determined as of November 2, 2017. For SFCs with 52-53 week taxable years, the election also applies to the December 31, 2017 E&P measurement date. The alternative method election avoids the practical difficulty of calculating E&P using a “hard-close” method without financials as of the close of a measurement date.
- No separate rules for calculation of E&P of non-controlled SFCs. The Proposed Regulations reject taxpayer requests for an alternative measurement method to determine the E&P of non-controlled SFCs, e.g., using audited financial statements. The Treasury and IRS reasoned that the requirement to determine E&P under US principles is consistent with requirements with respect to other provisions of the Code, including the passive foreign investment company rules.
- Changes in methods of accounting, entity classification elections and certain transactions are disregarded solely for purposes of section 965 if they result in a “change in the amount of a section 965 element.” As previewed by the IRS in Notice 2018-26, the Proposed Regulations provide that solely for purposes of determining the application of section 965, changes in methods of accounting and entity classification elections are disregarded if they reduce the amount of a section 965 inclusion, reduce a United States shareholder’s aggregate foreign cash position or increase the amount of FTCs that may be claimed with respect to such an inclusion. This rule creates significant uncertainty for taxpayers as noted in the Eversheds Sutherland Legal Alert, IRS appears to walk back disregard of certain accounting method changes in proposed section 965 regulations–does it make a difference? The Proposed Regulations also generally preserve the anti-avoidance rules from Notice 2018-26 that disregard certain transactions that occurred after November 2, 2017, for purposes of section 965.
- Previously taxed income is not excluded for purposes of determining the existence of an E&P deficit foreign corporation or the amount of a specified E&P deficit. Although previously taxed E&P is specifically excluded in determining whether an SFC is a deferred foreign income corporation (DFIC) with respect to which an inclusion may be required under section 965, the statute provides that previously taxed E&P is not excluded for purposes of determining if an SFC is an E&P deficit foreign corporation or the amount of a specified E&P deficit. The Proposed Regulations do not change the inconsistent treatment of previously taxed E&P under the statute, which will limit the amount of deficits available to offset amounts otherwise required to be included with respect to a DFIC.
- E&P adjustments to a deficit foreign corporation are effective on the first day of the SFC’s subsequent taxable year. The Proposed Regulations clarify that the E&P adjustment that results from the use of a deficit of an E&P deficit foreign corporation to offset DFIC E&P is taken into account in the SFC’s subsequent taxable year. This ensures deficit entities are not treated as having current year earnings, which could impact inclusions under other provisions of the Code.
- Taxes accrued after November 2, 2017, and on or before December 31, 2018, are pro-rated. For purposes of calculating the amount of post-1986 E&P subject to inclusion under section 965, the Proposed Regulations clarify, consistent with Prior Guidance, that taxes paid or accrued in the above period that are attributable to income that is accrued before November 2, 2017, are taken into account.
- Foreign currency translation is at the spot rate on December 31, 2017. For purposes of determining inclusions and similar amounts, the Proposed Regulations require use of the spot rate as of December 31, 2017. This is a departure from the rule for subpart F inclusions that are ordinarily translated at the average rate for the year.
Calculation of Section 965 Tax Liability – Although the net accumulated E&P is subject to tax, the taxpayer is allowed a deduction with respect to its inclusion with the effect that the tax is imposed at an effective rate of 15.5% to the extent of the amount of cash and cash equivalents held by a taxpayer’s SFCs, and at an effective rate of 8% for any amount in excess thereof. Key takeaways in the Proposed Regulations with respect to the calculation of the section 965 tax liability include:
- All members of a consolidated group are treated as a single corporation. For purposes of determining a taxpayer’s net accumulated E&P and making certain elections, including the section 965(h) deferral election, the Proposed Regulations make clear that all members of a consolidated group are treated as a single corporation. This clarification makes it less likely that a consolidated taxpayer will be subject to certain acceleration events under section 965(h).
- Election not to apply NOLs against transition tax applies to current year NOL. If a taxpayer makes the election under section 965(n) not to have net operating losses (NOLs) apply to offset the transition tax payable under section 965, that election applies to carryforward NOLs, as well as any NOL generated in the current year. This clarifies uncertainty arising from the technical definition of an NOL under the Code, which could have meant the election did not apply to exclude a current year NOL.
- Excludes hedges of non-cash assets from the definition of cash for purposes of determining the taxpayer’s deduction, but generally rejected taxpayer requests for guidance to exclude other assets from treatment as cash for this purpose. A number of taxpayers requested guidance that would have excluded certain assets from the statutory definition of cash assets on the basis that they were not liquid assets. The Proposed Regulations generally reject these requests as not consistent with the statutory framework of section 965.
FTC Considerations – FTCs are available with respect to amounts included under section 965, however, only for the portion that is included in income. FTCs related to the deductible portion of the inclusion are disallowed. Key takeaways with respect to the availability of FTCs include the following:
- Hovering deficits are not disregarded for purposes of determining FTCs. Although hovering deficits are taken into account in determining the post-1986 E&P (including a deficit) of an SFC, the hovering deficit rules continue to apply for all other purposes, including for purposes of determining the availability of any FTCs.
- Only a proportionate amount of FTCs related to the section 965 inclusion are permitted. Under the statute, no FTC is permitted for foreign taxes related to amounts for which a deduction is provided under section 965. The Proposed Regulations provide that the FTCs limited under section 965 include all taxes paid or accrued with respect to the inclusions, as well as any taxes paid on subsequent distributions of previously taxed E&P resulting from section 965 inclusions. Taxes paid by an E&P deficit foreign corporation are not available, even if the deficit is allocated against E&P of a DFIC.
- No FTCs with respect to non-CFC SFCs below the third tier. The Proposed Regulations confirm that the general tax credit rules apply, which limit FTCs creditable under section 902 with respect to non-CFCs to taxes paid by foreign corporations within three tiers of the United States shareholder.
Payment of Section 965 Tax Liability and Elective Deferral – Under section 965(h), taxpayers may elect to pay the section 965 transition tax over eight years, paying 8% of the liability in each of the first five years, 15% in the sixth year, 20% in the seventh year and 25% in the eighth year. Key takeaways from the Proposed Regulations with respect to the election include:
- Consolidated group treated as a single taxpayer for purposes of acceleration events. The Proposed Regulations include a number of “acceleration events” that may cause any amounts otherwise deferred under section 965(h) to become due and payable, and helpfully clarify that a consolidated group is treated as a single taxpayer for purposes of the section 965 calculation. Accordingly, the sale or liquidation of one member of a consolidated group in most cases would not constitute an acceleration event.
- Joint and several liability for transactions qualifying for an exception from acceleration. In the case of certain acceleration events involving the sale of a US shareholder or its assets, taxpayers may avoid triggering the liability if the acquiring entity becomes jointly and severally liable. The potential for joint and several liability will be an important consideration in merger and acquisition transactions involving companies that have made a section 965(h) election.
- No interim refund or credit for an overpayment of a section 965 installment payment. PMTA 2018-016 provides that the IRS will not issue a credit or refund to a taxpayer for an overpayment of a section 965 installment payment. The IRS will only issue a credit or refund once the section 965 liability has been paid in full. However, an overpayment of an installment reduces the remaining section 965 installment amount(s). The IRS will apply any excess amount to the next successive annual installment due, and to the extent such excess exceeds the amount of that installment due, then to the next such successive annual installment until the excess amount has been fully applied.
- Elections related to the application of section 965 are made with the taxpayer’s tax return or by October 9, 2018. The Proposed Regulations provide rules for making the relevant section 965 elections, which generally are required to be made with the taxpayer’s federal income tax return for the year including December 31, 2017 (or by October 9, 2018, for taxpayers that did not file for extensions and whose tax returns are therefore due before September 9, 2018). The Proposed Regulations state that section 9100 relief for late filing is generally not available for these elections.
Treatment of Previously Taxed E&P and Basis Adjustments – Amounts that are included under section 965 (or are not included because they are offset by E&P deficits) are treated as previously taxed E&P, such that additional US tax generally should not apply with respect to a subsequent distribution. The Proposed Regulations include certain clarifications regarding the calculation and treatment of previously taxed E&P, including the following:
- Section 986(c) only applies to foreign currency gain or loss on previously taxed E&P to the extent it was subject to tax under section 965. The Proposed Regulations clarify that no section 986(c) gain or loss is recognized on the distribution of previously taxed E&P attributable to the allocation of deficits to DFICs from E&P deficit foreign corporations.
- Taxpayers may elect to apply section 961(a) basis adjustments with respect to the allocation of deficits against E&P of DFICs if a corresponding reduction is made in the basis of the E&P deficit foreign corporation. The Proposed Regulations address concerns regarding basis adjustments with respect to previously taxed E&P that results from the allocation of a deficit from an E&P deficit foreign corporation against the earnings of a DFIC in determining the section 965 inclusion. The general rule under the Proposed Regulations is that no adjustment to basis under section 961 is made for these amounts, although the taxpayer may elect to reduce the basis in its E&P deficit foreign corporation, and make a corresponding increase in the basis of the DFIC to which the deficit was allocated. The reduction in basis could result in taxable gain (possibly in 2017 at the 35% corporate tax rate.) This election must be made for all SFCs and by all related United States shareholders.
- Stock of SFCs is not considered to be an exempt asset for purposes of expense allocation under section 861. The Proposed Regulations state that stock of an SFC is not an exempt asset for purposes of expense allocation under section 861. This provision will have implications for FTC utilization in the year of the inclusion, as well as potentially in future years depending on other guidance that is anticipated to be forthcoming.