The IRS Large Business and International (LB&I) division has recently announced that it will be focusing on the section 965 transition tax as its newest compliance campaign release.
In January 2017, the LB&I division began targeting several specific compliance issues as part of a new audit strategy referred to as ‘campaigns.’ The campaign based audit strategy is designed to help build a supportive infrastructure inside LB&I and redefine large business compliance work. Taxpayers should take note because these campaigns are key indicators of where the IRS will spend its audit resources.
Congress enacted the so-called transition tax (contained in section 965 of the Internal Revenue Code) as part of the Tax Cuts and Jobs Act (TCJA). Section 965 requires US shareholders to pay a transition tax on the untaxed foreign earnings of certain “specified foreign corporations” by deeming those earnings to be repatriated to the United States. Section 965 applies to the last taxable year of the relevant specified foreign corporation that begins before Jan. 1, 2018, and the amount included in income under section 965 is includible in the US shareholder’s year in which, or with which, such specified foreign corporation’s tax year ends. The vast majority of the section 965 liability was taken into account on taxpayer returns for 2017 and 2018 tax years. With this campaign, the IRS will devote significant resources to ensuring that taxpayers have reported the correct amount of transition tax liability.
As a part of the campaign, the IRS may request taxpayers to provide additional information related to any of the following:
- E&P corrections and changes in accounting methods/periods;
- Section 78 gross-up calculations;
- Disregarded cash reduction transactions;
- Disregarded E&P reduction transactions;
- Reductions in a taxpayer's pro rata share;
- Changes in entity classification elections; and
- Reconciliation between the “with” and “without” calculation.
In addition to conducting exams, LB&I has indicated that it will also be, "providing technical assistance to teams on 965, with a focus on identifying and addressing taxpayer populations with potential material compliance risk." Furthermore, selected returns will also be risk-assessed and examined for other material issues, especially as it relates to TCJA planning. This campaign aligns with the IRS's heightened focus around TCJA compliance.
Taxpayers should be mindful of this new campaign and review aspects of their section 965 calculations to identify potential weaknesses in their approach. For example, many taxpayers may have made simplifying assumptions concerning the earnings and profits of their foreign subsidiaries and the IRS may challenge these assumptions. We expect that taxpayers subject to this new enforcement campaign will receive Information Document Request (IDR) letters from the IRS soon. Taxpayers receiving IDRs should consult with their tax advisers prior to responding to such requests and develop a strategy to manage potential audit risks.