On January 15, 2019, Treasury and the Internal Revenue Service issued Final Regulations under Internal Revenue Code Section 965 (the “Final Regulations”) addressing the previously untaxed earnings of foreign subsidiaries by mandating the deemed repatriation of those earnings. The Final Regulations generally are consistent with the proposed regulations published on August 9 2018 (the “Proposed Regulations”), and discussed in a prior client alert. However, as described in this Client Alert, the Final Regulations make certain notable modifications in response to comments received on the Proposed Regulations, including the following:
- Determining a consolidated group’s aggregate foreign cash position as if all members of a consolidated group that are section 958(a) U.S. shareholders of a specified foreign corporation were a single section 958(a) U.S. shareholder.
- Amending the ordering rule for determining the 965 inclusion with respect to Section 1248 amounts and disregarded transactions between specified foreign corporations.
- Revising the application of the timing of the ordering rule to provide it applies for the taxable year of a specified foreign corporation in which an E&P measurement date occurs and for the last taxable year of a specified foreign corporation that begins before January 1, 2018.|
- Providing guidance on the basis consequences associated with taxpayers that make the election under Code Section 962, which provides that an individual who is a U.S. shareholder of a foreign corporation may elect to be taxed at corporate rates under for subpart F income, including the Section 965(a) inclusions - the Proposed Regulations had reserved on this important basis computation.
- Treating certain non-corporate entities as specified foreign corporations of a U.S. shareholder for purposes of determining the U.S. shareholder’s aggregate cash position.
- Revising the manner in which cash positions are determined by excluding certain assets including commodities.
- Taking into account certain changes in accounting methods.
- Taking into account foreign taxes associated with hovering deficits in determining the E&P for purposes of computing the 965 inclusion amount.
Section 965(a) generally provides that the subpart F income of a specified foreign corporation (“SFC”) (defined as a controlled foreign corporation (“CFC”) and any other foreign corporation with a 10% U.S. shareholder) in its last tax year beginning before January 1, 2018 (inclusion year) is increased by the greater of its accumulated post–1986 deferred foreign income as determined on two different measuring dates, November 2, 2017, and December 31, 2017. An SFC that has accumulated post–1986 deferred foreign income is referred to as a deferred foreign income corporation (“DFIC”).
Consolidated Return Provisions
The Proposed Regulations treated members of a U.S. consolidated group as a single U.S. shareholder for some purposes of applying Section 965 but not for purposes of the anti-double counting rules. As a result, loans between SFCs that are owned by different U.S. shareholders may not be eligible for relief, even if the U.S. shareholders are corporations that are members of the same consolidated group. Per the preamble to the Final Regulations, commenters noted that treating all members of a consolidated group that are Section 958(a) U.S. shareholders of an SFC as a single section 958(a) U.S. shareholder for purposes of Treas. Reg. § 1.965-3(b) but not for all purposes of determining the aggregate foreign cash position could result in overstatement of the aggregate foreign cash position. The Final Regulations have been amended to address these comments. Specifically, while the Proposed Regulations did not extend the anti-double counting relief for SFCs commonly owned by a single U.S. shareholder to SFCs held by different members of a consolidated group, the Final Regulations do so. Thus, while the Final Regulations do not treat members of a U.S. consolidated group as a single U.S. shareholder for all purposes in applying Section 965, they do so for purposes of determining the cash position of SFCs owned by the group within the meaning of Section 958(a).
The Final Regulations also changed certain aspects of the rules related to the operation in the consolidated return context of the Section 965(h) election to defer the Section 965 inclusion. The Proposed Regulations provided that such taxpayer must make the payments on the unpaid portion of the remaining installments if certain acceleration events occur, including, in the consolidated return context, if the person becomes a member of a consolidated group after not being a member of any consolidated group or the person’s consolidated group ceases to exist.
Within consolidated groups, the deconsolidation of a group member, or the addition of a new member can give rise to questions as to whether the 965(h) liability can be transferred among new and former members without triggering an acceleration event. The preamble to the Final Regulations recognized that the Proposed Regulations included exceptions where the consolidated group ceases to exist or a consolidated group is acquired and the acquired consolidated group members join a different consolidated group as of the day following the acquisition. Commenters requested additional exceptions to acceleration events to cover (1) a situation in which the consolidated group ceases to exist by reason of one or more members of the consolidated group transferring all of their assets to other members, with only one member remaining (for example, a consolidated group consisting only of a parent and a subsidiary ceasing to exist by reason of the subsidiary liquidating into the parent); and (2) a situation in which a consolidated group is wholly owned by a corporation that is not an includible corporation (within the meaning of section 1504(b)) when a section 965(h) election was made but subsequently becomes an includible corporation even though the situation does not involve the acquisition of stock of the common parent.
Treasury and the IRS, in response to these comments, provided additional contractual-based exceptions to acceleration events in the consolidated group context. For example, a taxpayer may transfer its Section 965(h) tax liability to a transferee by entering into an agreement with the Service. In addition, if a consolidated group terminates because it is acquired by another consolidated group, or because a shareholder of the common parent revokes its S election, or because all members of the consolidated group transfer all their assets to a single corporation, the Section 965(h) tax liability may be transferred.
Lastly, consistent with Notice 2018-07, the Final Regulations provide that all members of a consolidated group that are Section 958(a) U.S. shareholders of SFCs are treated as a single shareholder for purposes of Section 965(b) (determination of aggregate foreign E&P deficit amount), Section 965(c) (determination of the group's aggregate cash position with respect to a SFC under Treas. Reg. § 1.965-3), Section 965(h) (payment of Section 965 tax liability in installments), Section 965(k) (extension of statute of limitations), and Section 965(n) (election to forgo use of NOLs).
In contrast, for other purposes under section 965, each member of a consolidated group is treated as separate. These include determining the amount of a Section 958(a) U.S. shareholder’s initial Section 965(a) inclusion (before accounting for any E&P deficits or Section 965(c) deductions to reach the 15.5 percent or 8 percent rates), and preventing a Section 958(a) U.S. shareholder from being deemed to pay any foreign income taxes under Section 960 that are paid by a foreign corporation that is not in a qualified group with the shareholder.
Changes in Accounting Methods
The Proposed Regulations disregarded certain changes in methods of accounting and entity classification elections regardless of the motivations of the taxpayer. Specifically, any change in method of accounting for a taxable year of an SFC that ends in 2017 and 2018 is disregarded for purposes of determining the amounts of all Section 965 elements with respect to a U.S. shareholder if such change in method of accounting would otherwise change such Section 965 elements. Commenters noted that a change in accounting method election under Section 481 could result in a lower, or entirely eliminated Section 965 inclusion if, for example, the adjustment resulted in an increase in the Section 965 inclusion and the deemed foreign income taxes paid. Consistent with that comment, the Final Regulations provide that a change in accounting method is denied only if it results in a decrease in the Section 965 inclusion amount, a reduction in the aggregate cash position, or an increase in section 960 deemed paid taxes other than by reason of an increase in a section 965(a) inclusion amount.
The Proposed Regulations provided a five–step process to determine the coordination of Sections 951, 956, 959, and 965 (the “Ordering Rule”). As background, the Ordering Rule provides for E&P adjustments for each SFC in the following sequence: (1) determine “regular” Subpart F income of the SFC (i.e., without regard to Section 965); (2) account for SFC-to-SFC distributions made before January 1, 2018, but only for purposes of Section 959; (3) calculate the Section 958(a) U.S. shareholder’s Section 965(a) inclusion amount, which calculation should include the participation exemption and deficit allocation, as well as ignore any Subpart F income earned after the relevant measurement date for purposes of determining Section 959(c)(2) previously taxed income that is kicked out of accumulated post-1986 DFIC; (4) give effect to any other distributions from the SFC; and (5) determine the Section 956 amount of the SFC, including any PTI that should accordingly be reclassified as Section 959(c)(1) amounts.
The Final Regulations amend the ordering rule; more specifically (i) step 1 now requires Section 1248 amounts to be determined at the same time as the U.S. shareholder’s Subpart F inclusion is determined Section 965(a) inclusion year, which may result in a potential reduction in a taxpayer’s Section 965(a) inclusion; and (ii) step 4 now requires, for any distributions between SFC’s (initially step 2 transactions) that were disregarded as a result of Treas. Reg. § 1.965-4, that E&P is redetermined after the Section 965(a) inclusion amount, determined in step 3 (allowing for previously tax income (“PTI”) relating to earnings of the lower tier SFC’s that were now subject to the Section 965(a) inclusion under step 3).
Lastly, by statute, the two earnings and profits measurement dates, by statute, are November 2, 2017 and December 31, 2017. For certain fiscal year taxpayers (e.g. fiscal year tax years ending November 30th), the E&P measurement date of a corporation may not fall within an SFC’s last taxable year. The Final Regulations provide that the Ordering Rule applies for the taxable year of an SFC in which an E&P measurement date occurs and for the last taxable year of an SFC that begins before January 1, 2018—this rule accommodates differences that may exist for taxpayers that use fiscal years. For example, a fiscal year November 30, 2018 taxpayer would have one E&P measurement date of December 31, 2017.
Foreign Income Taxes Paid
The Proposed Regulations reserved on the interaction of Section 965 with Section 960(b). The Final Regulations apply Section 902 to a distribution that occurred prior to January 1, 2018 if such distribution was from one SFC to another SFC, and provide that, only thereafter, should Section 960 apply to Section 956 and/or Section 965(a) inclusions.
Clarification of Use of Section 965(b) PTI
Under the Proposed Regulations, a U.S. shareholder increases its PTI with respect to a DFIC by its Section 965(a) inclusion amount with respect to that DFIC, translated using the spot rate on December 31, 2017, provided the Section 965(a) inclusion amount is included in income by the U.S. shareholder. This PTI is referred to as Section 965(a) previously taxed earnings and profits (“Section 965(a) PTI”). Similarly, if a DFIC’s post-1986 E&P are reduced by the allocation of a deficit amount, the Proposed Regulations required the DFIC to increase its Section 965(b) previously taxed earnings and profits (“Section 965(b) PTI”) in the amount of that reduction, provided that the Section 958(a) U.S. shareholder includes the Section 965(a) inclusion amount with respect to the DFIC in income. The Proposed Regulations left ambiguous the situation where the Section 965(a) inclusion amount happened to be zero i.e., would that zero amount prevent an increase in the Section 965(b) PTI?
The Final Regulations clarify that Section 965(b) PTI is not limited to situations in which a U.S. shareholder had an actual Section 965(a) inclusion amount (e.g., had to pay cash taxes as a result of Section 965). Furthermore, the Final Regulations clarify that Section 965(b) PTI is treated as E&P attributable to amounts previously included in the income of a person under Section 951 for purposes of Section 1248(d)(1), which means that Section 965(b) PTI is excluded from a foreign corporation’s E&P for the purposes of calculating a U.S. shareholder’s Section 1248 amount. Lastly, the Final Regulations provide that, for purposes of the gain reduction rule, the Section 965(b) PTI amount should be determined in accordance with the spot rate as it was on December 31, 2017.
Section 962 Elections
With respect to Section 962 elections, the Proposed Regulations had “reserved” on providing guidance on the basis consequences for an individual who is a U.S. shareholder of a foreign corporation that elected to be taxed at corporate income tax rates with respect to subpart F income, including Section 965(a) inclusions. The Final Regulations now provide rules with respect to making the irrevocable election itself as well as rules pertaining to certain basis adjustment limitations for electing U.S. shareholders (e.g., a basis increase in the relevant stock is limited to the amount of tax paid). More specifically, a taxpayer that is paying the Section 965 tax liability over time in accordance with having made a Section 965(h) election increases its basis in the relevant stock as those payments are made.
Determining Cash Positions - Certain Exclusions
The Final Regulations exclude from the definition of an SFC’s cash position (1) certain commodities described in Section 1221 (i.e., inventory), and (2) certain items in Section 1221(a)(8). The Final Regulations achieve this result by not treating these items as actively traded personal property that would otherwise be treated as cash for purposes of the Section 965 rules (although dealers or traders in commodities are not permitted to use this exception). Additionally, certain types of financial instruments (e.g., forwards and shorts related to the excluded items above) are excluded from the cash position. Hedges associated with the excluded items set forth above are also excluded to the extent that they hedge a non-cash equivalent asset of the taxpayer. The Final Regulations provide that hedges not satisfying this criterion are treated as cash positions, noting that an instrument can hedge both a cash equivalent and a non-cash equivalent asset.
Non-Corporate Entities and Cash Positions
Under the Proposed Regulations, a partnership is treated as an entity for purposes of determining whether it is a U.S. shareholder with respect to an SFC. Moreover, for purposes of determining of determining who and what entity qualifies as a Section 958(a) U.S. shareholder with respect to an SFC, and consequently the Section 958(a) stock owned by the Section 958(a) U.S. shareholder, a controlled domestic partnership will be treated as a foreign partnership provided two requirements are satisfied. The first requirement is that the controlled domestic partnership must be a Section 958(a) U.S. shareholder and thus own Section 958(a) stock of the SFC. The second requirement is that if the controlled domestic partnership (and all other controlled domestic partnerships in the chain of ownership of the SFC) were treated as foreign, (i) the SFC would continue to be an SFC, and (ii) at least one U.S. shareholder of the SFC would be treated as a Section 958(a) U.S. shareholder of the SFC, and would be treated as owning (within the meaning of Section 958(a)) tested Section 958(a) stock of the SFC through another foreign corporation that is a direct or indirect partner in the controlled domestic partnership. In the event these two requirements are met and the controlled domestic partnership is treated as a foreign partnership, the domestic partnership will lose its status as a United States shareholder thereby causing domestic corporations holding an interest (directly or indirectly in the partnership) to be treated as owning stock owned by the partnership, with result that such domestic corporations could be treated as U.S. shareholders with respect to DFICs held by the partnership.
The Final Regulations revise the controlled domestic partnership application by providing a controlled domestic partnership is treated as a foreign partnership for all partners (rather than solely with respect to U.S. shareholders), assuming the requisite conditions are present. By treating the partnership as a foreign partnership, and thereby disabling the partnership’s status as a separate entity, each partner is treated as directly holding the partnership’s CFC stock. The result of this aggregate treatment is that a partnership does not separately allocate among its partners a Section 965 amount. Moreover, because each partner is treated as directly holding stock of the underlying SFCs, it is also deemed to directly hold stock in any relevant DFICs, which may positively impact the ultimate Section 965 amount. The Final Regulations also treat a controlled domestic partnership that is treated as a foreign partnership as a foreign pass–through entity for purposes of the basis–shifting election to address insufficient basis on future distributions of Section 965(b) PTI created under Section 965(b)(4)(A) (discussed in part above).
The Final Regulations also provide a rule that disregards a portion of the cash position of non-corporate entities which are treated as SFC’s for purposes of Section 965. More specifically, for purposes of computing its aggregate foreign cash position, the rule allows a U.S. shareholder of the relevant non-corporate entity, which is treated as an SFC, to limit the U.S. shareholder’s pro rata share of the non-corporate entity’s cash position to the ownership percentage the U.S. shareholder has in the specified corporation which owned the relevant non-corporate entity. Put differently, if a U.S. shareholder owned 60 percent of a specified corporation, which in turn owned 100 percent of a foreign partnership, the U.S. shareholder would only include 60% of the partnership’s cash position in its aggregate foreign cash position.
Per the Proposed Regulations, any deficit related to post-1986 E&P, including a hovering deficit, of an SFC is taken into account for purposes of determining the post-1986 E&P (including a deficit) of the SFC. Pursuant to the Final Regulations, to the extent the hovering deficit would have been absorbed by E&P accrued during the taxable year but for a Section 965(a) inclusion, the Final Regulations indicate that the taxes that relate to the hovering deficit are taken into account for purposes of determining post-1986 foreign income taxes.
The Final Regulations include two different transition rules related to basis adjustments like the Proposed Regulations, the Final Regulations allow for U.S. shareholders to make certain basis adjustments with respect to each DFIC and each E&P deficit foreign corporation. The Final Regulations adjust the timing related to such basis adjustments (in accordance with Notice 2018-78) by providing a transition rule for returns due before May 6, 2018, which requires that the election be made by that date. Furthermore, for those taxpayers who made a basis election on or before February 5, 2019, the election is now revocable if the taxpayer attaches a statement of revocation to its amended return by May 6, 2019. These extended timelines for making the election will allow taxpayers more time to analyze whether making the election is a proper choice. Finally, certain U.S. shareholders who owned a DFIC but not an E&P deficit foreign corporation are excepted from making basis elections altogether.
With respect to assets held by E&P deficit foreign corporations, the Final Regulations generally provide that downward basis adjustments are limited to the amount of basis in the relevant asset, providing a measure of parallel treatment to the rule for upward basis adjustments, which were limited in the Proposed Regulations (and are still limited in the now-Final Regulations).