The Tax Cuts and Jobs Act introduced many changes to the tax code, with little time for taxpayers or professionals to prepare for them. One of the most complex changes involved the revision of Internal Revenue Code section 965, which overhauled the way the United States taxes earnings from ownership in foreign corporations. The author gives a brief overview of the new IRC section 965 and provides a detailed demonstration of how to properly calculate and pay the required taxes.
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The newly revised Internal Revenue Code (IRC) section 965 looks very little like its old self; in fact, it represents a new way of taxing foreign corporations. The old section 965 was the one-year Temporary Dividends Received Deduction introduced as part of the American Jobs and Creation Act of 2004. The new section 965, enacted by the Tax Cuts and Jobs Act of 2017 (TCJA), taxes the retained earnings of foreign corporations that are attributable to U.S. shareholders. The income inclusion calculated on the U.S. shareholder’s tax return will include the untaxed earnings of the foreign corporation for the last tax year of the business beginning before January 1, 2018. Thus, most U.S. shareholders’ future tax returns will contain income that they have not had to include on previous years’ returns. This will include income that consists of post-1986 earnings and profits (E&P) allocated to U.S. shareholders through complex calculations. The mere thought of repatriation of 31 years of accumulated foreign earnings in a single year is a scary proposition for many. Fortunately, the tax rate for these repatriated earnings is discounted, and taxpayers can pay any balance owed as a result over eight years and without interest.
IRC section 965 does unfortunately present some uncertainty around how to do the actual calculations and how it interacts with other existing sections of the tax code. The late enactment of the TCJA required the IRS to revise forms and update its systems to be able to process tax returns containing income from the new rules after the beginning of the 2018 filing season. Coupled with the already strained budget, this led to late and incomplete releases of official guidance. On March 15, the IRS published a set of FAQs that provided some practical guidance on how to execute the IRC section 965 transition tax on tax forms. The IRS did not finish revising Form 5471 by the April 17 filing deadline, and their systems were not ready to accept electronically filed tax returns containing the repatriation of earnings until after April 2. Furthermore, CPAs originally needed to have all of a client’s tax liabilities computed in time for them to pay 8% of the section 965 tax liability by April 17 if they intended to pay over eight years; IRS Publication 5292, which provided necessary calculation instructions, was not published until April 6 and contained confusing worksheets and errors. Subsequently, dates for making the election to pay over eight years were extended, and leeway was allowed for CPAs to amend early-filed returns to take advantage of these changes. The IRS released 249 pages of proposed regulations on August 1; this author anticipates that additional clarifications will have to be released, along with revisions to Form 5471, hopefully before the new filing season begins.
It is important to go deeper than the conceptual level and a glossary of key terms to recognize how the changes to who is a U.S. shareholder, what is a controlled foreign corporation, and how the repeal of the IRC section 958(b)(4) constructive ownership rules will affect taxpayers. This article provides an overview of the new IRC section 965 and illustrates how to run the math and arrive at the correct numbers to put on the tax forms and newly required statement.
The Basics of IRC Section 965
All U.S. persons who meet the criteria to be a U.S. shareholder [as defined in IRC section 957(c)] must include their pro rata share of deferred earnings from foreign corporations on their tax returns and pay the required tax. As noted above, the rate is more favorable than in the past, and IRC section 965(h)(1) allows the tax liability to be paid over eight years (with no interest) if the taxpayer so elects. Taxpayers should have begun making these disclosures and payments with their tax returns that included the last taxable year of the foreign corporation that begins before January 1, 2018 (i.e., their 2017 tax returns).
How these taxes are to be calculated and paid cannot be answered in a couple of short sentences, but the gist is that U.S. shareholders of foreign corporations with positive accumulated post-1986 E&P will include in their taxable income a portion of the accumulated E&P on their tax return. The amount will depend on such things as whether the U.S. shareholder also owned a foreign corporation that had negative E&P and whether the corporation was cash or asset heavy. Taxpayers will be allowed to utilize foreign tax credits they have for the current year, as well as any carried forward from the last 10 years, to offset the section 965 tax as long as they are for the same income category. Individual taxpayers will also be allowed to make an election under section 962 to have the section 965 income taxed using the corporate rates and take a foreign tax credit for a portion of the foreign taxes that are deemed paid by the foreign corporation; they will then be required to prepare and attach a sworn statement and elections to their tax return. When the return has been completed, the tax pools and previously taxed income must be adjusted, and a plan for next year to mitigate the new global intangible low-taxed income (GILTI) and base erosion and anti-abuse tax (BEAT) regimes must be formulated.
The basic steps are outlined in Notice 2018-7, 2018-13 the section 965 FAQs, and Publication 5292, with additional clarification and examples in the proposed regulations.
Calculating IRC Section 965 Taxable Income: An Example
Consider a U.S. shareholder of three foreign corporations. Each corporation is a calendar year reporter, and the IRC section 965 inclusion year is 2017. The taxpayer’s position is detailed in Exhibit 1.
Position of Example Taxpayer
Is the client a U.S. shareholder for the purposes of IRC section 965? This term includes U.S. citizens, green card holders, resident aliens, and domestic entities that own (directly, indirectly, or constructively) more than 10%, by vote or value, of a non–U.S. corporation. Foreign corporations with U.S. shareholders are called specified foreign corporations (SFC); this includes controlled foreign corporations (CFC) and any foreign corporation that has one or more domestic corporate shareholders. An important caveat to this decision is the fact that IRC section 965(e)(2) expands CFC to include 10–50 corporations. If the foreign entity is also a passive foreign investment company (PFIC) and not a CFC under the traditional definition, it is excepted from the application of IRC section 965. Note that some taxpayers will now be U.S. shareholders under the newly expanded definition of CFC, where in prior years they were not.
The taxpayer in the example above is considered a U.S. shareholder because it owns at least 10% of each company. Furthermore, each corporation is considered an SFC.
Does the SFC have accumulated post-1986 E&P, or is it carrying a deficit on the balance sheet? Correctly answering this question will require some math; the number is calculated twice on two different dates (Nov. 2, 2017, and Dec. 31, 2017) and does not include U.S. effectively connected income (which is already being taxed under a different code section), subpart F income (also taxed under another code section), and previously taxed income (PTI). The date of November 2, 2017, was chosen because it is the date the tax bill was introduced in the House of Representatives; it was intended to negate any preemptive movements to lower the earnings subject to taxation, or the cash postition (which dictates the tax rate that will be imposed on the earnings), once the bill was public. This number also does not include E&P prior to January 1, 1987, nor does it include E&P from periods when the corporation did not meet the definition of an SFC.
If, after the requisite calculations are pre-formed, the amount for both testing dates is a positive number, the taxpayer officially has a deferred foreign income corporation (DFIC). Conversely, if the amount for both dates is a negative number, the taxpayer is considered to have an E&P deficit foreign corporation. If the number is positive E&P on one date and negative on the other, the corporation is a DFIC. Note that there are certain situations where a CFC is neither (see Notice 2018-13, section 3.01).
For the taxpayer in this example, after a negative adjustment for U.S. effectively connected income (ECI), PTI, and current year Subpart F, CFC 1 and CFC 3 have positive E&P and are considered DFICs, while CFC 2 has a negative accumulated post-1986 E&P and is considered an E&P deficit foreign corporation.
Calculate the IRC section 965(a) earnings amount. Start with the larger amounts of accumulated post-1986 E&P for each DFIC. Ignore the E&P deficit foreign corporations for this step. For each testing date, multiply the E&P for each DFIC by the taxpayer’s ownership percentage; the greater of the two is the IRC section 965(a) earnings amount. For the example taxpayer, this is $157,000 for CFC 1 and $11,250 for CFC 3, for a total E&P amount of $168,250 (see Exhibit 2).
Calculation of Example, IRC Section 965 Earnings Amount
Calculate the IRC section 965 inclusion amount. First, reduce the IRC section 965 earnings amounts for each DFIC by the prorated E&P deficit from the deficit CFCs. Using the loss amount on the November 2 testing date, prorate the result to each DFIC to reflect the taxpayer’s ownership percentage:
Total deficit E&P × accumulated post-1986 E&P of each deficit CFC ÷ Total accumulated post-1986 E&P for all CFCs
Finally, subtract the prorated deficit from each DFIC accumulated post-1986 E&P. This result is the IRC section 965 inclusion amount, as stated in Notice 2018-13. The example taxpayer’s calculations are shown in Exhibit 3.
Calculation of Example IRC Section 965 Inclusion Amount
Determine the taxpayer’s aggregate cash position. This calculation is required to apportion the IRC section 965 inclusion amount to the two tax rates of 15.5% and 8%. Amounts allocated to the cash positions will be taxed at the higher rate, and the balance will be taxed at the lower rate.
The aggregate cash position is the greater balance of cash and cash equivalents as determined using two different dates: December 31 of the inclusion year (generally 2017 for individuals), and the average of December 31 of the two prior years (generally 2015 and 2016). This is then prorated to the taxpayer’s percentage of ownership for each corporation.
The term cash and cash equivalents includes U.S. or foreign cash, net accounts receivable (receivables less payables), actively traded investments, certificates of deposit, commercial paper, government securities, short-term obligations, and any other asset the IRS identifies as economically equivalent (such as loans between related parties).
As seen in Exhibit 4, the example taxpayer had the larger aggregate cash position on December 31, 2017, at $76,250. This is the portion of the inclusion amount that will be subject to a 15.5% tax rate; the excess will be taxed at 8%.
Calculation of Example Aggregate Cash Position
Calculate and apply the participation exemption. In order for the final tax liability to be assessed at the appropriate rates, the amount of income that is added to taxable income on the return must be reduced. This calculation uses the same thought process as the capital gains rate differential adjustment for long-term capital gains on Form 1116, Foreign Tax Credit. The reduction percentages are as follows:
- 55.7% = 15.5% rate equivalent percentage (for the aggregate cash position)
- 77.1% = 8% rate equivalent percentage (for the balance)
The calculations for the taxpayer in this example are in Exhibit 5.
Calculation of Example Participation Exemption for IRC Section 965 Inclusion Amount
Add these numbers together and drop the result on Form 1040, line 21, with a marginal notation of “SEC 965.” This is the amount of income to be included on the tax return.
Calculating Foreign Tax Credits
The next steps entail the determination of how foreign taxes deemed paid by each of the foreign corporations can be utilized to reduce the IRC section 965 tax obligation if the taxpayer is making a section 962 election to be taxed as a corporation. Of course, this involves another few rounds of math.
First, determine the individual’s pool of deemed paid taxes for the accumulated post-1986 E&P. Use the regular rules to determine the balance of the tax pool.
Compute the amount of disallowed foreign tax credits. Before the deemed paid taxes can be used, they must be reduced to prevent double dipping. The first reduction is for amounts allocated to current year subpart F inclusions. The familiar equation is:
Deemed tax pool × subpart F income ÷ (accumulated E&P − PTI)
This amount is available as a foreign tax credit, but it is not part of the IRC section 965 computation. Form 1118 must be attached to the return when making a section 962 election for the transition tax.
Next, reduce the deemed paid taxes by the applicable participation exemption percentage. Since the income added to the return is reduced, that reduction must be mirrored before applying credits against the resulting tax. In addition, the IRC section 78 gross-up rules still apply, and an amount equal to the creditable taxes will also be added to Schedule B as a dividend, as well as to the section 965 exclusion amount to calculate the tax liability under section 11. Note that only C corporations and individuals who make the election under IRC section 962 would be eligible.
Using basic proration equations, tax is allocated to current subpart F income, then to the section 965(a) inclusion amount. The example taxpayer’s calculations are shown in Exhibits 6 and 7. Note that since CFC 2 was in a deficit position, its tax pool is not used in the current year, but instead carried forward.
Calculation of Example Participation Exemption for Deemed Paid Foreign Tax Credits
Form 1116 Foreign Taxes Paid and IRC Section 78 Gross-Up
Compare the tax before and after adding the IRC section 965 income and section 78 gross-up to the return. The difference in tax will be the IRC section 965 tax amount, which can be paid in a single installment or multiple installments. The marginal notation “965” should be added on Form 1040, line 44. If the taxpayer elects to pay the amount over eight years, make an entry on Form 1040, line 73, for the amount to be paid over time, tick box d, and add “TAX.”
The example taxpayer’s final tax calculations are shown in Exhibit 8. Exhibit 9 contains a schedule of payments over eight years, should the taxpayer make that election.
Tax with and without IRC Section 965(a)
Payment of IRC Section 965 Tax Using Section 965(h)(1) Election
An “IRC 965 Transition Tax Statement” containing specific numbers from the calculations outlined in steps 1–10 should be completed and attached to the filing. If not using the template available on the IRS website, preparers should be sure to include a jurat at the bottom signed by the taxpayer. In addition, if the taxpayer is making any of the allowed elections, including the eight-year payment option, the election should be attached in proper form and contain all the required information. The taxpayer must make the first and second installment payments no later than the due date of the next tax return (without extensions) in order to keep the section 962 election valid. Lastly, be sure to file any other forms that may be required, such as Forms 5471, 8938 and the FBAR (Report of Foreign Bank and Financial Accounts).
Doing the Heavy Lifting
The global economy is here to stay, and U.S. taxpayers are not going to stop investing in foreign corporations anytime soon. While the first tax season under the new IRC section 965 has come and gone, clients with significant foreign ownership interests will continue to expect CPAs to help them properly account for and pay the correct taxes on income from those interests. CPAs should be diligent in monitoring their clients’ foreign assets and determining which ones qualify for inclusion and taxation.