Finalized Transition Tax Regulations: Adjustments to E&P and Basis
The IRS has issued highly anticipated final regulations under Internal Revenue Code Sec. 965, the Transition Tax (TT) provision added by the Tax Cuts and Jobs Act. Sec. 965 generally requires U.S. shareholders to pay a “transition tax” on the untaxed foreign earnings of certain specified foreign corporations (SFC) as if those earnings had been repatriated to the United States.
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For a summary of the changes brought forth under the final regs, see our blog post “Finalized Transition Tax Regulations: An Overview”. Here we’ll focus on adjustments to earnings and profits (E&P) and basis, as well as the application of Sec. 986(c) dealing with previously taxed E&P.
Deferred Foreign Income Corporations
Code Sec. 965 imposes a TT on untaxed foreign earnings of foreign subsidiaries of U.S. companies and individuals by deeming those earnings to be repatriated. More specifically, Code Sec. 965(a) provides that, for the last tax year of a deferred foreign income corporation (DFIC) that begins before January 1, 2018 (such year of the DFIC, the “inclusion year”), the Subpart F income of the corporation or the individual (as otherwise determined for such tax year under Code Sec. 952) is increased by the greater of:
- The accumulated post-1986 deferred foreign income of such corporation determined as of November 2, 2017, or
- The accumulated post-1986 deferred foreign income of such corporation determined as of December 31, 2017 — each such date, a “measurement date,” and the greater of the accumulated post-1986 deferred foreign income of the corporation as of the measurement dates, the “Code Sec. 965(a) earnings amount.”
Furthermore, the Sec. 965(a) earnings amount that would otherwise be considered under Sec. 951(a)(1) by a U.S. shareholder with respect to a DFIC is reduced by the amount of such U.S. shareholder’s aggregate foreign E&P deficit, which is allocated to such DFIC. The Code Sec. 965(a) earnings amount reduced as described in the preceding sentence is referred to in IRS guidance as the “Code Sec. 965(a) inclusion amount.”
For purposes of Code Sec. 965, a DFIC is any SFC of a U.S. shareholder that has accumulated post-1986 deferred foreign income (as of a measurement date) greater than zero.
Controlled Foreign Corporations
Sec. 965(e)(1) provides that the term “specified foreign corporation” means any controlled foreign corporation (CFC), and any foreign corporation with respect to which one or more domestic corporations is a U.S. shareholder.
Under Sec. 957, a CFC is a foreign corporation for which:
- More than 50% of the total combined voting power of all classes of stock is entitled to vote, or
- The total value of the stock of the corporation is owned (directly, indirectly or constructively) by U.S. shareholders.
A U.S. shareholder for CFC purposes is a U.S. person who owns 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation.
Code Sec. 951(a)(1) provides that every person who is a U.S. shareholder of a CFC, and who owns stock in such corporation on the last day in the CFC’s tax year, must include in his or her gross income, subject to exceptions, the amount determined under Code Sec. 956 with respect to such shareholder.
Under Code Sec. 959(a)(1), distributions of previously taxed E&P (PTI) are excluded from the U.S. shareholder’s gross income. Meanwhile, Code Sec. 961 provides rules with respect to adjustments to basis of stock in CFCs. To the extent that an amount excluded from gross income under Code Sec. 959(a) exceeds the adjusted basis of the stock or other property with respect to which it’s received, the amount is treated as gain from the sale or exchange of property.
For individuals who elected Code Sec. 962 treatment of their TT income, the income does not become PTI and so there are different result for these individuals than discussed in the previous paragraph.
Proposed regs issued in 2018 contain rules relating to adjustments to E&P and basis to determine and account for the application of Code Sec. 965(a) and Code Sec. 965(b), as well as a rule that limits the amount of gain recognized in connection with the application of Code Sec. 961.
The proposed regs also set forth an ordering rule for the last tax year of a specified foreign corporation that begins before January 1, 2018, and the tax year of a U.S. shareholder in which or with which such year ends. The rule relates to adjustments to E&P for purposes of determining a U.S. shareholder’s inclusions under Code Sec. 951(a)(1) and the treatment of distributions under Code Sec. 959.
The IRS has determined that the ordering rule’s limited application to E&P for an SFC’s last tax year beginning before January 1, 2018, is too narrow given that it’s intended to apply for purposes of determining post-1986 E&P and accumulated post-1986 deferred foreign income on the E&P measurement date on November 2, 2017; that measurement date may not fall within an SFC’s last tax year beginning before January 1, 2018. The final regs address this issue by providing that the ordering rule applies for the tax year of an SFC in which an E&P measurement date occurs, as well as for the last tax year of a specified foreign corporation that begins before January 1, 2018.
The final regs provide rules concerning the ordering of the determination of foreign income taxes deemed paid with respect to an inclusion or distribution, after the E&P adjustments are determined in accordance with applicable regulations. The final regs provide that, for purposes of determining the consequences of a dividend (under the deemed foreign tax paid credits of Former Code Sec. 902 and Code Sec. 960) or an inclusion under Code Sec. 951(a)(1), respectively, the ordering rule applies. However, there’s an exception: Former Code Sec. 902 is applied with respect to any distributions from the specified foreign corporation described in applicable regulations that aren’t disregarded under other applicable regulations before Code Sec. 960 is applied with respect to an inclusion or a distribution described in applicable regulations.
For individual US Shareholders, there is no issue about the determination of foreign income taxes deemed paid as they do not receive the benefits of Code Sec. 902 and Code Sec. 960 discussed in the previous paragraph. Furthermore, the regs. have reserved on the issue of PTI distribution under Code Sec. 959 when a Code Sec. 962 election has been made by an individual. There may be some unexpected consequences for individuals who did not make the Code Sec. 962 election related to the TT income, but then make this election in future (2018+) years.
Other E&P Implications
Code Sec. 986(c) provides rules with respect to foreign currency gain or loss on distributions of PTI attributable to exchange rate movements between the times of deemed and actual distribution.
In addition, the final regs state that the other rules of Former Sec. 902 and Sec. 960 apply. The final regs also provide that the E&P consequences of a distribution between specified foreign corporations disregarded for purposes of Code Sec. 965 pursuant to applicable regulations are determined after adjustments for Sec. 965(a) inclusions while the consequences of other distributions are determined.
Sec. 1248 provides a rule under which a U.S. person includes in gross income as a dividend (out of the CFC’s untaxed accumulated E&P) any gain recognized on the sale or exchange of a foreign corporation’s stock that was a CFC during a specified period. The final regs include a provision regarding the proper points at which to determine and consider inclusions under Sec. 1248 with respect to the Sec. 965 rules.
Adjustments to the E&P of DFICs
Under proposed regulations, the E&P described in Sec. 959(c)(2) — (formerly Subpart F income that is PTI) are increased by an amount equal to the reduction to a U.S. shareholder’s pro rata share of the Sec. 965(a) earnings amount of the DFIC under Sec. 959(b), “provided the U.S. shareholder includes the Code Sec. 965(a) inclusion amount with respect to the deferred foreign income corporation in income.”
Because the rule was intended to limit the availability of Sec. 965(b) PTI to situations in which a Sec. 965(a) inclusion amount was included only if there was a Sec. 965(a) inclusion amount, the rule is revised to so clarify.
Also, the final regs clarify that Sec. 965(b) PTI are treated as E&P attributable to an amount previously included in the income of a person under Sec. 951 for purposes of Sec. 1248(d)(1).
The proposed regs provided that, in general, no adjustments to basis of stock or property are made under Sec. 961 (or any other provision of the Code) to account for the reduction of a U.S. shareholder’s pro rata share of the Sec. 965(a) earnings amount of a DFIC by a portion of its aggregate foreign E&P deficit.
In addition, an election under the proposed regs allows a U.S. shareholder’s basis in the stock of a DFIC or applicable property with respect to the DFIC to be increased by an amount equal to the Sec. 965(b) PTI of the DFIC with respect to the U.S. shareholder. If the relevant return was due before September 10, 2018, the proposed regs provide that the basis election had to be made by October 9, 2018 (the “transition rule”).
The final regs provide that the transition rule will apply with respect to returns due (regardless of any extension) before 90 days after the regs are published in the Federal Register. In such cases, the basis election must be made no later than 90 days after the regs are published.
Additionally, the final regs provide that, if a basis election was made when or before the regs were published, the basis election may be revoked by attaching a statement to an amended return filed no later than 90 days after the regs are published.
Application of Sec. 986(c)
The proposed regs provide that, for purposes of Code Sec. 986(c), foreign currency gain or loss with respect to distributions of Sec. 965(a) previously taxed E&P would be determined based on movements in the exchange rate between December 31, 2017, and the date on which such E&P were distributed. The final regs provide an additional rule that would prevent gain recognition attributable to fluctuations in exchange rates.
Complexities to Consider
Moore Stephens Doeren Mayhew has been following these new provisions closely, especially as they relate to individuals who own SFCs (and CFCs). There are several new forms that must now be completed on a going forward basis related to the TT, even if initially reported in your 2017 income tax returns. We would be pleased to discuss these new forms, including the additional reporting required, and determine how best to comply in an efficient manner.
James J. Miesowicz. CPA
Matthew Hitchcock, CPA