United States

IRS releases new guidance relating to the transition tax

IRS Notice provides penalty relief and other technical guidance

TAX ALERT  | 

On April 2, 2018, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued Notice 2018-26 (the ‘Notice’), the fifth in a series of notices and other guidance on the section 965 transition tax. Previous guidance on the section 965 transition tax was issued in Notice 2018-07, Notice 2018-13, and Rev. Proc. 2018-17. The IRS also posted a list of Frequently Asked Questions and answers on IRS.gov. Treasury and the IRS expect to issue additional guidance in the future.

Notice 2018-26 describes regulations to be issued, including rules intended to prevent the avoidance of section 965, rules and procedures relating to certain special elections under section 965, and guidance on the calculation and payment of the transition tax. The Notice also offers relief to taxpayers from certain estimated tax requirements and penalties arising from the enactment of the transition tax and the change to existing stock attribution rules in the Tax Cuts and Jobs Act (TCJA).

Background

Section 965, as newly enacted by the TCJA, imposes a one-time transition tax on untaxed foreign earnings of foreign subsidiaries of U.S. shareholders by deeming those earnings to be repatriated. The amount deemed repatriated is the greater of the untaxed foreign earnings and profits (E&P) as of Nov. 2, 2017, or Dec. 31, 2017. Foreign E&P held in the form of cash and cash equivalents (referred to as the ‘cash position’) is taxed at a 15.5 percent rate, and the remaining E&P is taxed at an 8 percent rate. The tax due may be paid immediately or in installments over a term of eight years with no interest.

Anti-avoidance rules

Treasury and the IRS intend to issue anti-avoidance rules providing that transactions occurring in whole or in part on or after Nov. 2, 2017, will be disregarded if undertaken with a principal purpose of reducing the section 965 transition tax liability and if the section 965 transition tax liability would, in fact, be reduced absent this new rule.

The Notice says that some transactions are presumed to be undertaken for a principal purpose of reducing the section 965 transition tax, which can be rebutted only if the facts and circumstances clearly show otherwise. These transactions are cash reduction transactions, earnings and profits reduction transactions, and pro-rata share transactions. A taxpayer that takes the position that the presumption is rebutted must attach a statement to its income tax return disclosing that it has rebutted the presumption.

The Notice also states that accounting method changes made for a taxable year of a specified foreign corporation that ends in 2017 or 2018 will be disregarded for purposes of determining the section 965 transition tax if the accounting method change reduces the tax. The rule will not apply to method changes requested prior to Nov. 2, 2017. Entity classification elections made on or after Nov. 2, 2017, will also be disregarded if applying the election would reduce the section 965 transition tax liability.

Special elections under section 965

Treasury and the IRS have determined that if a domestic pass-through entity (partnership or S corporation) is a U.S. shareholder in a deferred foreign income corporation (DFIC), the section 965 inclusion amount is to be determined at the level of the domestic pass-through entity. However, a U.S. person that is a domestic pass-through owner, directly or indirectly, is subject to tax on its share of the inclusion amount. Treasury and the IRS intend to issue rules allowing domestic pass-through owners to make elections under section 965(h) (election to pay section 965 transition tax liability in installments), section 965(m) (statement for real estate investment trusts electing deferred inclusions) and section 965(n) (election not to apply net operating loss deduction).

Further, rules will clarify that a domestic pass-through owner who is an individual (including a trust or estate) and a U.S. shareholder with respect to the DFIC may make an election under section 962 with respect to the individual's share of the section 965 amount.

Treasury and the IRS also intend to issue rules clarifying that elections made under section 965(n) would apply to both current year losses as well as net operating loss carryovers and carrybacks.

Determination of cash measurement dates

The amount of a foreign corporation’s earnings that are treated as held in cash or cash equivalents (and thus subject to the higher 15.5 percent rate) is equal to the greater of the cash position determined on the last day of the foreign corporation’s taxable year for which the one-time inclusion occurs (‘final cash measurement date’), or the average cash positions of the foreign corporation determined on (i) the last day of the foreign corporation’s taxable year that ended before Nov. 2, 2017 (the ‘second cash measurement date’) and (ii) the last day of the foreign corporation’s preceding taxable year (‘first cash measurement date’).

A specified foreign corporation may not be owned by a particular U.S. shareholder on all cash measurement dates. For example, the specified foreign corporation may cease to exist or the specified foreign corporation’s stock may be sold or acquired between dates. Treasury and the IRS intend to issue rules specifying the first, second and final cash measurement dates. A U.S. shareholder must take into account its pro rata share of the cash position of a specified foreign corporation as of any cash measurement date of the specified foreign corporation on which such U.S. shareholder is a U.S. shareholder of the specified foreign corporation, regardless of whether the U.S. shareholder is a U.S. shareholder of the specified foreign corporation on any other cash measurement date, including the final cash measurement date.

For purposes of applying this rule, a 52-53-week tax year is deemed to begin on the first day of the calendar month nearest to the first day of the 52-53-week tax year, and is deemed to end or close on the last day of the calendar month nearest to the last day of the 52-53-week tax year, as the case may be.

Treatment of certain accrued foreign income taxes for purposes of determining untaxed foreign E&P

Treasury and the IRS intend to issue rules providing that, for purposes of determining a specified foreign corporation's untaxed foreign E&P as of Nov. 2, 2017, any foreign income tax that accrues (i) within the specified foreign corporation's U.S. tax year that includes Nov. 2, 2017, and (ii) after Nov. 2, 2017, but on or before Dec. 31, 2017, will be allocated between the respective portions of the foreign tax base on which the accrued foreign taxes are determined that are attributable to the part of the U.S. tax year ending on Nov. 2, 2017, and the part of the U.S. tax year beginning after Nov. 2, 2017.

Itemized deductions and the alternative minimum tax (AMT)

Treasury and the IRS have determined that the 965(c) participation exemption is not treated as an itemized deduction by individuals, including for purposes of the 2 percent floor under section 67 or the AMT deduction disallowance in section 56.

Net accounts receivable of a specified foreign corporation

Rules will provide that the terms ‘accounts receivable’ and ‘accounts payable’, for purposes of calculating the net accounts receivable of a specified foreign corporation, will include only receivables or payables with a term of less than one year.

Penalty relief

The Notice provides that underpayment penalties will not be imposed under section 6654 (failure by individual to pay estimated income tax) or section 6655 (failure by corporation to pay estimated income tax) with respect to a taxpayer’s net tax liability under section 965 and the amounts are not included when calculating required installments. However, if a taxpayer fails to timely pay its net tax liability under section 965 when due, other sections of the Code may apply. For example, additions to tax could result under section 6651 (failure to file tax return or to pay tax), and installment payments could be accelerated under section 965(h)(3).

Downward attribution of stock

The TCJA amended the stock ownership attribution rules of section 958(b) so that the stock of a foreign corporation owned by a foreign person is attributed ‘downward’ under section 318(a)(3) to (1) a 50 percent owned U.S. corporate subsidiary, or (2) a partnership in which the foreign corporation owns equity.

The Notice illustrates downward attribution with the following example: assume that person A owns 100 percent of Domestic Corp and 1 percent of Partnership. Assume further that U.S. Citizen owns 10 percent of Partnership and 10 percent by vote and value of Foreign Corp The remaining 90 percent by vote and value of Foreign Corp is owned by non-U.S. persons that are unrelated to A, U.S. Citizen, Domestic Corp and Partnership.

As a result of the changes enacted as part of the TCJA, Partnership is treated as owning 100 percent of the stock of Domestic Corp and 10 percent of the stock of Foreign Corp. Domestic Corp, in turn, is treated as owning the stock in Foreign Corp treated as owned by Partnership, converting Foreign Corp from a non-specified foreign corporation, under prior law, into a specified foreign corporation subject to section 965. Because U.S. Citizen is a U.S. shareholder with respect to Foreign Corp, absent an exception, U.S. Citizen would be required to include amounts in gross income under section 951(a)(1) by reason of section 965 with respect to Foreign Corp. According to the Notice, the result would be the same regardless of whether A or Partnership or both are domestic or foreign persons.

Treasury and the IRS have determined that it would pose compliance difficulties for taxpayers and administrative difficulties for the government to require a U.S. person to determine whether a foreign corporation with respect to which it is a U.S. shareholder is a specified foreign corporation if the foreign corporation may be a specified foreign corporation solely by reason of downward attribution under section 318(a)(3)(A) of stock from a partner to a partnership when such partner has only a de minimis interest in such partnership. Accordingly, Treasury and the IRS will issue rules that provide that solely for purposes of determining whether a foreign corporation is a specified foreign corporation, stock owned directly or indirectly, by or for a partner will not be considered owned by a partnership under sections 958(b) and 318(a)(3)(A), if the partner owns less than 5 percent of the interests in the partnership’s capital and profits.

The Notice provides key guidance and relief in connection with calculating a taxpayer’s obligations under new section 965. However, we expect even more guidance from Treasury and the IRS regarding the application of section 965 and other provisions of the TCJA. Taxpayers should continue to monitor for new developments.

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