The Tax Cuts and Jobs Act (TCJA) added Section 965 to the Internal Revenue Code to tax earnings held offshore by controlled foreign corporations (CFCs) going back to 1987. In general, this transition tax is the price that U.S. persons who have accumulated earnings in CFCs must pay for the ability to repatriate earnings tax-free going forward.1 Given that it is generally too late to engage in planning to mitigate the transition tax, this article focuses principally on issues that are likely to persist for years after a taxpayer has paid the transition tax. After providing a brief overview of the transition tax, this article addresses issues associated with distributions of previously taxed earnings and profits (PTEP) created by the transition tax, issues that are likely to be contentious in an Internal Revenue Service audit of the transition tax, and events that can trigger an acceleration of Section 965 tax liability otherwise deferred until future years. As of this writing, the final regulations under Section 965 have been released but not yet published in the Federal Register.
The transition tax imposes two different rates of tax on post-1986 earnings and profits (E&P) for deferred foreign income corporations (DFICs). A DFIC is, with respect to any U.S. shareholder, any controlled foreign corporation or foreign corporation of such U.S. shareholder “which has accumulated post-1986 deferred foreign income [as of either November 2, 2017, or December 31, 2017] greater than zero.”2 The transition tax imposes a 15.5 percent tax rate on DFIC cash earnings and profits and an eight percent tax rate on DFIC noncash earnings and profits.3 In addition, Section 965(b) permits U.S. shareholders of multiple CFCs to use earnings and profits deficits of certain CFCs to offset positive earnings and profits in other CFCs. Earnings and profits that are fully taxed under Section 965(a) are referred to as “[S]ection 965(a) previously taxed earnings and profits,” whereas earnings and profits that are not taxed because they were offset by an earnings and profits deficit of another CFC under Section 965(b) are referred to as “[S]ection 965(b) previously taxed earnings and profits.” Section 965(g) has made foreign tax credits available to offset the transition tax subject to a “haircut.” Under Section 965(h), taxpayers are permitted to elect to pay the transition tax in installments over eight years. Section 965 provides special rules and elections for S corporations and real estate investment trusts owning DFIC stock.4 Section 965(n) provides an election not to use net operating losses to offset Section 965 tax liability.
Section 965(a) has created a variety of new issues regarding PTEP. Two of the most common key issues are addressed here: the ordering of PTEP distributions and situations in which PTEP basis adjustments can continue to make it impossible to distribute PTEP without U.S. tax being imposed.
Notice 2019-1 provides guidance on some of the most significant issues created by the TCJA, including guidance on the order in which different kinds of PTEP are treated as having been distributed. Before the TCJA, only Subpart F inclusions under Section 951(a) resulted in the creation of PTEP.5 After the TCJA, PTEP could be created by the operation of Section 951(a) alone, the transition tax, or the Section 951A tax on global intangible low-taxed income (GILTI). The TCJA has also resulted in the creation of several new categories of PTEP that need to be tracked separately for the purposes of calculating foreign tax credits, including Section 965(a) previously taxed earnings and profits (Section 965(a) PTEP) and Section 965(b) earnings and profits (Section 965(b) PTEP).6 Prior to Notice 2019-1, Section 959 generally provided that PTEP was treated as distributed on a last-in, first-out basis.7 Notice 2019-1 modified this rule, however, to provide that Section 965(a) PTEP is treated as distributed first, followed by Section 965(b) PTEP.8 After a CFC has distributed all of its Section 965(a) PTEP and Section 965(b) PTEP, PTEP continues to be treated as distributed on a last-in, first-out basis. This is an important rule, because all PTEP is not created equal. Although Section 960(b) may provide foreign tax credits with respect to withholding and other taxes incurred as a result of a distribution of PTEP, the Section 965 foreign tax credit haircut continues to apply to a distribution of Section 965(a) PTEP and Section 965(b) PTEP.9 In addition, the amount of foreign currency gain or loss recognized under section 986(c) may vary depending upon the particular PTEP distributed.
Section 961 and the regulations thereunder provide rules regarding basis adjustments with respect to PTEP. In general, Section 961(a) requires a U.S. shareholder to increase its basis in stock of a CFC at the end of the taxable year in which the CFC earns PTEP.10 Section 961(b) requires a U.S. shareholder to reduce its basis in stock of a CFC at the time the CFC makes a distribution of PTEP.11 However, under the Treasury Regulations, while Section 965(a) PTEP and Section 965(b) PTEP are both treated as PTEP for federal income tax purposes, a U.S. shareholder generally increases its basis in CFC stock for Section 965(a) PTEP but not for Section 965(b) PTEP.12 The Regulations permit a U.S. shareholder to increase its basis in CFC stock as a result of including Section 965(b) PTEP only if the U.S. shareholder makes a corresponding reduction in the basis of the CFC with the E&P deficit that gave rise to the Section 965(b) PTEP.13 Although it may seem beneficial under most circumstances to increase basis in stock of a CFC that has PTEP while decreasing basis in the stock of a CFC that has an E&P deficit, the U.S. shareholder will recognize gain in the CFC in which it has the E&P deficit if it does not have sufficient basis to offset the basis reduction in the stock of the CFC.14 Fortunately, the Regulations allow taxpayers to make a partial election to increase basis in stock for Section 965(b) PTEP to the extent the corresponding reduction in basis of the stock of the CFC that has the E&P deficit does not result in a gain.15
As with many aspects of the TCJA, the transition tax contains a number of ambiguities that are likely to cause many taxpayers to have significant disputes with the IRS when it audits their liability for this tax. One source of such disputes is the distinction between cash and noncash E&P, given that cash E&P is taxed at a rate that is 7.5 percent higher than noncash E&P. Section 965(c)(3)(B) generally provides that cash, net accounts receivable, personal property of a type and for which there is an established market, commercial paper, certificates of deposit, government securities, foreign currency, and any obligation with a term of less than one year constitute a taxpayer’s “cash position” for the purposes of Section 965. In addition, the legislative history states that a taxpayer’s “cash position” is intended to consist of its “liquid” assets. Given the ambiguity in the definitions of the various items constituting a taxpayer’s cash position and the legislative history discussing liquidity, many taxpayers have requested guidance on whether particular assets, such as commodities held as inventory or stock of publicly traded subsidiaries, were part of their cash position. The IRS and the Treasury Department have provided only limited relief by excluding commodities described in Section 1221(a)(1) or Section 1221(a)(8) from the definition of “cash position.”16 Many other similar requests for relief regarding the definition of “cash position” have been rejected. Similarly, the IRS and the Treasury Department seem to have left open for dispute the meaning of items such as “net accounts receivable” and the treatment of notional cash pooling for the purposes of Section 965. As a result, these issues will likely be disputed for many years to come.
Section 965(h) generally permits taxpayers to pay the transition tax in installments over an eight-year period. However, Treasury Regulation Section 1.965–7 provides that the liability for unpaid installments is accelerated as a result of certain events. Events that trigger this acceleration include the failure to make timely payment of an installment over the eight-year period, cessation of business by a person that is not an individual, and an event that results in the person’s no longer being a United States person.17 As described in more detail below, some internal restructuring and M&A transactions can also be triggering events, including certain situations in which corporations join a consolidated group or groups cease to file a consolidated return.18
In general, a liquidation, sale, exchange, or other disposition of substantially all of the assets of the person (including in a Title 11 or similar case, or in the case of an individual, by reason of death).19 Even if the liquidation, sale, exchange, or other disposition occurs entirely between related parties, unpaid installments can be accelerated. In addition, a corporation can have its unpaid installments accelerated if it becomes a member of a consolidated group.20 A consolidated group can have its unpaid installments accelerated if the group either ceases to exist or otherwise discontinues the filing of a consolidated return.21 This rule applies even in situations in which the parent of the consolidated group is acquired in a tax-free reorganization or other transaction described in Treasury Regulations Section 1.1502-75(d)(2) or (d)(3).22 However, in transactions involving a liquidation, sale, exchange, or other disposition or in one of the transactions described above involving consolidated groups, the parties to the transaction may be permitted to enter into a transfer agreement under which the transferee is permitted to assume the liability for the unpaid installments.23 Ordinarily, the transfer agreement must be filed within thirty days of the acceleration event.24 With respect to acceleration events that occurred before December 31, 2018, the transfer agreement must have been filed by January 31, 2019.25
Jay Singer is a partner at McDermott Will & Emery.
- Section 245A provides a 100 percent dividends-received deduction for foreign-source dividends paid to domestic corporations that satisfy certain requirements. Unfortunately, individuals are not eligible for the Section 245A dividends-received deduction, although many individuals who owned CFCs when the TCJA was implemented are liable for the transition tax.
- Section 965(d) and Section 965(e).
- Section 965(c). More precisely, under Section 965(a), U.S. shareholders increased their Subpart F income of their DFICs by the greater of deferred foreign income determined as of November 2, 2017, or December 31, 2017. Section 965(c) then provided a deduction to U.S. shareholders, causing cash earnings and profits to be taxed at 15.5 percent and noncash earnings and profits to be taxed at eight percent.
- Section 965(i) (providing special rules for S corporations); Section 965(l) (providing special rules for expatriated entities); and Section 965(m) (providing special rules for real estate investment trusts).
- Section 959(a).
- Notice 2019-1 lists a total of sixteen different categories of PTEP. Other categories of PTEP created by the TCJA include Section 245A(e)(2) PTEP from hybrid dividends between CFCs that are treated as resulting in Subpart F income and Section 964(e) PTEP.
- Section 959(c).
- Notice 2019-1 Section 3.02.
- Treas. Reg. Section 1.965-5(b).
- Treas. Reg. Section 1.961-1(a).
- Treas. Reg. Section 1.961-2(a).
- Treas. Reg. Section 1.965-2(e).
- Treas. Reg. Section 1.965-2(f).
- Treas. Reg. Section 1.965-2(h).
- Treas. Reg. Section 1.965-2(f)(2)(ii)(B)(2).
- Treas. Reg. Section 1.965-1(f)(13).
- Treas. Reg. Section 1.965-7(b)(3).
- Treas. Reg. Section 1.965-7(b)(3)(ii)(B).
- Treas. Reg. Section 1.965-7(b)(3)(ii)(E).
- Treas. Reg. Section 1.965-7(b)(3)(ii)(F).
- Id.; Treas. Reg. Section 1.1502-13(j)(5).
- Treas. Reg. Section 1.965-7(b)(3)(iii).
- Treas. Reg. Section 1.965-7(b)(3)(iii)(B)(2)(i).
- Treas. Reg. Section 1.965-7(b)(3)(iii)(B)(2)(i).