On April 2, 2018, the U.S. Treasury Department and the Internal Revenue Service (IRS) released Notice 2018-26 (the Notice), which provides guidance addressing the so-called "transition tax" or "toll charge" described in Section 965 of the Internal Revenue Code of 1986, as amended (the Code).1
Prior to enactment of legislation commonly referred to as the Tax Cuts and Jobs Act (the Act), U.S. owners of foreign corporations generally could defer U.S. tax on the earnings of such corporations (other than with respect to certain types of passive income), but would be subject to U.S. tax when the earnings were repatriated (e.g., upon receipt of a dividend from the foreign corporation). The Act, however, introduced a modified "territorial" system that generally exempts U.S. corporations from U.S. tax on foreign source dividends from any foreign corporation (other than a "passive foreign investment company") in which the U.S. corporation owns stock representing at least 10% of the foreign corporation's combined voting power or value.
As part of the transition to this territorial system, each U.S. person (i.e., an individual who is a U.S. citizen or resident, or a U.S. corporation, partnership, or trust) that owns, directly, indirectly through certain foreign entities, or by attribution, stock representing at least 10% of the combined voting power of certain foreign corporations (a 10% U.S. shareholder) and that owns, directly or indirectly (but not by attribution), stock of such foreign corporations must include in its income all or a portion of such foreign corporations' accumulated offshore earnings. Please see our previous WSGR Alert for more details. With certain exceptions, a foreign corporation that is a controlled foreign corporation (as defined in Section 957) or that is owned, directly or indirectly, by one or more domestic corporations that are 10% U.S. shareholders (such foreign corporation, a specified foreign corporation, or SFC) and that has accumulated offshore earnings is termed a "deferred foreign income corporation," or "DFIC." The transition tax imposed by Section 965 generally only applies to 10% U.S. shareholders of DFICs and operates by increasing each DFIC's subpart F income in its last taxable year that begins before January 1, 2018.
SFC Status and "Downward Attribution" to Partnerships
For purposes of determining whether a U.S. person is treated as a 10% U.S. shareholder of a foreign corporation, ownership of the foreign corporation's stock may be attributed between entities and their owners. For example, a foreign corporation's stock that is owned by a partnership is attributed "upward" to its partners, and a foreign corporation's stock owned by a partner is attributed "downward" to the partnership. Prior to the enactment of the Act, for purposes of determining whether a U.S. person was a 10% U.S. shareholder, Section 958(b)(4) effectively "turned off" the downward attribution otherwise required by these rules (meaning that only upward attribution was applied) such that stock held (or treated as held) by a foreign person would not be attributed "downward" to a U.S. person. The Act repealed Section 958(b)(4), which has the effect of increasing the number of U.S. persons subject to Section 965.
In connection with the repeal of Section 958(b)(4), the Notice acknowledges that it would pose compliance difficulties for taxpayers, and administrative difficulties for the IRS, to require a shareholder of a foreign corporation to determine whether the corporation is an SFC if the corporation qualifies as an SFC solely by reason of a "downward" attribution of stock from a partner to a partnership in which such partner owns only a de minimis interest. Accordingly, the Notice announces that, for purposes of determining whether a foreign corporation is an SFC, stock held by a partner will not be attributed to a partnership if the partner owns less than 5% of the interests in the partnership's capital and profits. The Treasury Department and the IRS also plan to issue regulations to this effect.
Calculating the Transition Tax: Cash Measurement Dates and Foreign Income Taxes
As described above, Section 965 generally requires each 10% U.S. shareholder that directly or indirectly owns stock of a DFIC to take all or a portion of the DFIC's accumulated offshore earnings into income in 2017 or 2018, depending on when the DFIC's tax year ends for U.S. federal income tax purposes.
Special tax rates apply to the amounts required to be taken into income by 10% U.S. shareholders (whether individuals or corporations) under Section 965. For U.S. corporations, the applicable tax rates on the earnings required to be taken into account under Section 965 generally are 8% and 15.5%, depending on whether the earnings have been reinvested in the applicable foreign corporation's business, or retained in the form of cash or cash equivalents. In determining the extent to which the 8% or the 15.5% rate applies to the income required to be included by a 10% U.S. shareholder, Section 965 requires the 10% U.S. shareholder to determine its share of the cash held by any of its SFCs (termed the "cash position") as of certain dates. The Notice states that the Treasury Department and the IRS intend to issue regulations providing that these dates generally will fall between November 1, 2015, and December 31, 2018, depending both on the dates on which the 10% U.S. shareholder held an interest in the applicable SFC, and the dates on which the SFC's tax years ended for U.S. federal income tax purposes. The Notice further states that these regulations will require a 10% U.S. shareholder to take into account certain cash positions of an SFC regardless of whether the 10% U.S. shareholder owned any interest in the SFC as of the other applicable measurement dates.
The Notice also describes regulations that will be issued to address how foreign income taxes accrued after November 2, 2017, but on or before December 31, 2017, are taken into account under Section 965. Foreign income taxes accrued on or before November 2, 2017, generally would reduce a DFIC's accumulated offshore earnings as of that date for purposes of Section 965, but foreign income taxes for 2017 that are imposed on a calendar-year basis may not have accrued for U.S. federal income tax purposes on November 2, 2017, even though they may become payable with respect to earnings accumulated as of that date. Thus, for purposes of determining an SFC's accumulated offshore earnings as of November 2, 2017, the regulations will effectively accelerate the accrual of certain foreign income taxes that are accrued for U.S. federal income tax purposes before January 1, 2018 in the SFC's U.S. taxable year that includes November 2, 2017, and are attributable to periods ending on or before November 2, 2017.
Anti-Avoidance Rules
According to the Notice, the Treasury Department and the IRS intend to issue regulations that would disregard transactions undertaken after November 2, 2017, with a principal purpose of reducing a 10% U.S. shareholder's tax liability under Section 965. For purposes of this rule, "cash reduction transactions," "E&P reduction transactions," and "pro rata share transactions" will be presumed to be undertaken with such a principal purpose (which presumption can be rebutted only if facts and circumstances clearly establish otherwise). The Notice describes these transactions as follows:
- Cash reduction transaction. A transfer of cash, accounts receivable or cash equivalents by an SFC to (or an assumption by an SFC of accounts payable of) one of the SFC's 10% U.S. shareholders or a person related to one of the SFC's 10% U.S. shareholders, such that the 10% U.S. shareholder's aggregate foreign cash position is reduced.
- E&P reduction transaction. A transaction between an SFC and any of: (i) a 10% U.S. shareholder of such SFC; (ii) another SFC of such 10% U.S. shareholder; or (iii) any person related to such 10% U.S. shareholder that in each case reduces the accumulated offshore earnings of such SFC or another SFC of such 10% U.S. shareholder.
- Pro rata share transaction. A transfer of the stock of an SFC to a 10% U.S. shareholder of the SFC (or a person related to such 10% U.S. shareholder) that: (i) reduces such 10% U.S. shareholder's share of the SFC's earnings taken into account for purposes of calculating the 10% U.S. shareholder's tax liability under Section 965; (ii) increases such 10% U.S. shareholder's pro rata share of an earnings deficit of such SFC; or (iii) reduces such 10% U.S. shareholder's pro rata share of the cash position of such SFC.
In addition, the regulations will provide certain "per se" rules for cash reduction, E&P reduction, and pro rata share transactions, including a rule treating a distribution by an SFC in a cash reduction transaction as per se being undertaken with a principal purpose of reducing a U.S. shareholder's tax liability under Section 965 if either: (i) there was a plan for the distributee to transfer cash or certain cash equivalents to any SFC of the 10% U.S. shareholder; or (ii) the distribution was not pro rata and was made to a foreign person related to the 10% U.S. shareholder. As a corollary, the regulations will provide that a cash reduction transaction that is a distribution to a 10% U.S. shareholder will be treated per se as not being undertaken with a principal purpose of reducing the U.S. shareholder's tax liability in any other circumstance. Helpfully, the regulations will provide that cash reduction transactions or E&P reduction transactions occurring in the ordinary course of business are not presumed to be undertaken with a principal purpose of reducing a U.S. shareholder's tax liability under Section 965; instead, a facts and circumstances test will apply.
The Notice also states that regulations will be issued under Section 965 that disregard certain changes in accounting methods for taxable years of SFCs that end in 2017 or 2018, unless the request for a change was filed before November 2, 2017. Similarly, any "check the box" election filed on or after November 2, 2017, will be disregarded for purposes of Section 965 if such election would have the effect of reducing any U.S. shareholder's tax liability under Section 965.
Certain Elections
The Notice provides guidance addressing how to make certain elections under Section 965 if stock of an SFC is owned by a domestic pass-through entity (such as a partnership or an S corporation). Specifically, the Notice states that owners of such entities will be permitted to make the elections under Sections 965(h) (providing for payment of the Section 965 tax liability over eight years), 965(m) (relating to income recognition by real estate investment trusts), and 965(n) (disregarding the mandatory income inclusions under Section 965 when calculating net operating losses), regardless of whether the owners are themselves 10% U.S. shareholders of a DFIC.
In contrast, the Notice states that the Treasury Department and the IRS will issue regulations prohibiting an individual who recognizes income under Section 965 with respect to a DFIC, but is not itself a 10% U.S. shareholder of the DFIC, from making an election under Section 962 with respect to such income inclusions. This may occur if the individual is an owner of a domestic pass-through entity that is a U.S. shareholder of the DFIC, but the individual does not directly or indirectly own stock representing at least 10% of the voting power of the DFIC. For an individual who is eligible for and makes a valid Section 962 election, the Notice clarifies that the incremental tax under Section 965 would be calculated as if the individual were a corporation (i.e., at the 8% and 15.5% rates, which are obtained by taking into account the deductions afforded by Section 965(c)).
For further information or to discuss any of the provisions described above, please contact Greg Broome (gbroome@wsgr.com, 415-947-2139); Myra Sutanto Shen (msutantoshen@wsgr.com, 650-565-3815); Jonathan Zhu (jzhu@wsgr.com, 650-849-3388); or any member of the tax practice at Wilson Sonsini.
