The final section 965 regulations (the “Final Regulations”), updated by the IRS and Treasury on Jan. 24, 2019, and published in the Federal Register on Feb. 5, 2019, provide that if an acceleration event or a triggering event occurred on or before Feb. 5, 2019, then a transfer agreement must be filed by March 7, 2019 in order to be considered timely filed. Failure to timely file such agreement could accelerate payment of any outstanding section 965 transition tax liability. The Final Regulations specify that section 9100 relief is not available if a transfer agreement is filed late.
Many types of transactions could cause acceleration of tax that a taxpayer elected to defer under the special provisions contained in sections 965(h) or 965(i). In particular, taxpayers who have restructured their organizations in light of the Tax Cuts and Jobs Act should examine closely whether transactions that occurred prior to Feb. 5, 2019 inadvertently resulted in a termination of their election to defer payment of the transition tax. These regulations make clear that such deferral may be reinstated only if a valid transfer agreement is filed by March 7, 2019. However, it is important to note that the timely filing of a transfer agreement is not a guarantee that a taxpayer’s deferral will be reinstated.
The transition tax
For most taxpayers, section 965 was applicable in the 2017 tax year. In general, section 965 levies a mandatory one-time transition tax on the untaxed post-1986 foreign earnings of certain foreign corporations owned by a U.S. shareholder. Foreign earnings considered held in the form of cash and cash equivalents are taxed at a 15.5 percent rate, and the remaining earnings are taxed at an eight percent rate. Taxpayers may make an election under section 965(h) to pay the transition tax in installments over a term of eight years with no interest. Additionally, a shareholder of an S corporation can make an election under section 965(i) to defer payment of the transition tax indefinitely. However, certain so-called “acceleration” events (with respect to a section 965(h) election) and “triggering” events (with respect a section 965(i) election) may result in the taxpayer’s transition tax liability becoming due immediately.
Triggering or accelerating payment of deferred transition tax
Under the Final Regulations, an acceleration event or triggering event includes, among other things, a “liquidation, sale, exchange, or other disposition of substantially all of the assets” of the electing taxpayer. The preamble to the Final Regulations indicates that even an exchange or disposition of substantially all of the assets resulting from a downstream tax-free reorganization, “F” reorganization, or a transaction described in section 351 or 721 may constitute a disposition of substantially all of the taxpayer’s assets. For example, a U.S. corporation that transfers shares to another corporation in an otherwise tax-free reorganization generally will accelerate the amount of any deferred transition tax unless the U.S. corporation files a transfer agreement with the IRS within 30 days of the transfer. If that transfer occurred on or before Feb. 5, 2019, the agreement must be filed by March 7, 2019.
However, the rules for shareholders of S Corporations are potentially more treacherous. For example, assume a U.S. individual taxpayer owns 100 percent of an S corporation that, in turn, owns 100 percent of a foreign corporation as its sole asset. In 2017, U.S. individual had a transition tax liability pursuant to section 965 and made an election under section 965(i) to defer payment of this tax indefinitely. In 2018 or 2019, to take advantage of the lower 21 percent corporate tax rate or to mitigate the impact of the global intangible low-taxed income (GILTI) rules, U.S. individual instructs the S corporation to contribute all of its shares in the foreign corporation to a newly formed U.S. C corporation (owned 100 percent by the S corporation). Although the U.S. individual and the S corporation continue to own 100 percent of the foreign corporation indirectly, the contribution transaction may nonetheless constitute a triggering event, resulting in an acceleration of the due date of any outstanding deferred section 965 liability. Unfortunately, under the Final Regulations, this S corporation shareholder may not file a transfer agreement to maintain his or her Section 965(i) election under this particular set of facts, but may be able to if another triggering event occurs.
However, the shareholder may be able to make an election under Section 965(h), which would allow the taxpayer to pay the transition tax over the eight year period described above, provided the taxpayer files the election (by filing a transfer agreement) within 30 days of the transfer of the shares (here the transfer of all of the S corporation’s assets). If the triggering event is other than a disposition of the assets of the S Corporation, then the shareholder may be able to file his or her Section 965(h) election by the extended tax return due date for the year in which the triggering event occurs.
Since many events can result in inadvertent termination of a taxpayer’s election to defer payment of their section 965 liability, taxpayers who have made such an election should work closely with their advisors to determine whether their activities have resulted in an acceleration or triggering event. Even if the acceleration or triggering event is one for which relief is available, the Final Regulations set forth many additional requirements as to the form and substance of the transfer agreement that taxpayers should carefully review to ensure they preserve their deferral of the transition tax, if at all possible.