Transition tax - enough about how it works; here is what doesn’t work

by Eversheds Sutherland (US) LLP
Contact

Eversheds Sutherland (US) LLP

The Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) released Notice 2018-16 (the Notice) providing additional guidance regarding the transition tax in section 965 of the Internal Revenue Code of 1986, as amended (the Code), which was added by Public Law 115-97, commonly known as the Tax Cuts and Jobs Act of 2017 (the Act). See the prior Eversheds Sutherland alerts on the Act. While the Treasury and the IRS issued prior transition tax guidance in Notice 2018-07, Notice 2018-13, Revenue Procedure 2018-17 and a list of “frequently asked questions” (FAQs), the Notice strikes a new tone by not only offering technical guidance but also targeting steps that taxpayers may have been contemplating or already implemented to reduce their transition tax liability (the 965 Liability), including disregarding:

  • transactions undertaken with a principal purpose of reducing the 965 Liability; and
  • certain changes in method of accounting and entity classification.

This alert summarizes the new anti-avoidance rules and other technical guidance described in the Notice with respect to which the Treasury and the IRS intend to issue regulations effective beginning the first taxable year of a foreign corporation to which section 965 applies.

Eversheds Sutherland Observation: Pending the issuance of additional guidance, the broad anti-avoidance rules announced in the Notice may dissuade taxpayers from pursuing planning they were otherwise considering to mitigate their 965 Liability.


Background

Section 965 of the Code imposes a one-time transition tax on a United States shareholder with respect to its investment in controlled foreign corporations (CFCs) and certain other foreign corporations (collectively, specified foreign corporations or SFCs). The tax is generally imposed on the net aggregate amount of the United States shareholder’s pro rata shares of the previously untaxed foreign earnings and profits (E&P) of such SFCs. The tax is imposed at an effective rate of 15.5% to the extent of the amount of cash and cash equivalents held by such corporations, and 8% for any amount in excess thereof. Taxpayers may elect to pay the tax over eight years, paying 8% of the liability in each of the first five years, 15% in the sixth year, 20% in the seventh year and 25% in the eighth year. Previously untaxed foreign E&P subject to section 965 is the greater of such amount as of November 2, 2017, or December 31, 2017. The amount of cash and cash equivalents is the greater of (i) the amount as of the close of the last taxable year beginning before January 1, 2018, and (ii) the average amount as of the close of the last two taxable years ending prior to November 2, 2017. 

The Treasury and the IRS have issued previous guidance regarding the transition tax. Notice 2018-07 and Notice 2018-13 provided that the Treasury and the IRS intend to issue regulations for determining amounts included in gross income of a United States shareholder under section 951(a)(1) by reason of section 965. Revenue Procedure 2018-17 modified the circumstances under which the IRS grants approval of certain foreign corporations for changes in accounting periods in order to prevent the avoidance of the purpose of section 965. The FAQs provide guidance with respect to certain matters related to return filing and tax payment obligations arising under the section 965 anti-avoidance rules.

Section 965(c)(3)(F) and section 965(o) contain anti-avoidance measures. Section 965(c)(3)(F) provides that the Treasury and the IRS may disregard a transaction for section 965(c) purposes, if a principal purpose of any transaction was to reduce the aggregate foreign cash position. Also, section 965(o) provides that the Treasury and the IRS can issue regulations or other guidance to prevent the avoidance of section 965, including through a reduction in E&P, a change in an entity classification and a change in accounting methods. Although certain transactions, elections and method changes will be disregarded for purposes of determining the 965 Liability, they still may be respected for other tax purposes. 

Anti-Avoidance Rules

  • Treatment as an Anti-Avoidance Transaction: A transaction generally will be treated as an anti-avoidance transaction and disregarded for purposes of determining the 965 Liability if:
    • such transaction occurs (in whole or in part) on or after November 2, 2017;
    • such transaction is undertaken with a principal purpose of reducing the 965 Liability of such United States shareholder (a Reduction Principal Purpose); and
    • such transaction would otherwise reduce the 965 Liability of such United States shareholder.
  • The 965 Liability Reduction: Under the Notice, the 965 Liability of a United States shareholder is treated as reduced by a transaction if such transaction:
    • reduces a section 965(a) inclusion amount of such United States shareholder with respect to any SFC;
    • reduces the aggregate foreign cash position of such United States shareholder; or
    • increases the amount of foreign income taxes of any SFC deemed paid by such United States shareholder under section 960 as a result of an inclusion required by section 965.
  • Presumption Rules: The Notice provides per se rules for certain transactions, specifies that certain other transactions are presumed to be undertaken with a Reduction Principal Purpose, and provides rules for rebutting the presumptions.
    • Cash Reduction Transactions: A Cash Reduction Transaction is any transfer of cash, accounts receivable or cash-equivalent assets by an SFC to a United States shareholder of such SFC or a person related to a United States shareholder of such SFC, or an assumption by an SFC of an accounts payable of a United States shareholder of such SFC, if such transfer would otherwise reduce the aggregate foreign cash position of such United States shareholder. Cash Reduction Transactions are generally presumed to be undertaken with a Reduction Principal Purpose.
      • Ordinary Course Exception: Cash Reduction Transactions that occur in the ordinary course of business are not presumed to be undertaken with a Reduction Principal Purpose (but may be determined to have such a purpose based on the facts and circumstances).
      • Per Se Reduction Principal Purpose: A Cash Reduction Transaction that is a distribution by an SFC of a United States shareholder will be treated per se as having a Reduction Principal Purpose if (i) at the time of the distribution, there was a plan or intention for the distributee to transfer, directly or indirectly, cash, accounts receivable or cash-equivalent assets to any SFC of such United States shareholder, or (ii) the distribution is a non-pro-rata distribution to a foreign person that is related to such United States shareholder (a Specified Cash Reduction Transaction).
Eversheds Sutherland Observation: It appears that this per se Reduction Principal Purpose rule applies regardless of the relevant amounts of the Cash Reduction Transactions and the planned subsequent cash transfer and even to Cash Reduction Transactions that occur in the ordinary course of business, both of which would be surprisingly harsh results.
  • Per Se No Reduction Principal Purpose: A Cash Reduction Transaction that is a distribution by an SFC to a United States shareholder of such SFC (other than a Specified Cash Reduction Transaction) will be treated per se as not being undertaken with a Reduction Principal Purpose.
  • E&P Reduction Transactions: A transaction between an SFC and any of (i) a United States shareholder of such SFC, (ii) another SFC of a United States shareholder of such SFC, or (iii) any person related to a United States shareholder of such SFC is presumed to be undertaken with a Reduction Principal Purpose if such transaction would otherwise reduce the accumulated post-1986 deferred foreign income or the post-1986 undistributed earnings of such SFC or another SFC of any United States shareholder of such SFC (a E&P Reduction Transaction).
  • Ordinary Course Exception: E&P Reduction Transactions that occur in the ordinary course of business are not presumed to be undertaken with a Reduction Principal Purpose (but may be determined to have such a purpose based on the facts and circumstances).
Eversheds Sutherland Observation: It appears that this E&P Reduction Transaction presumption applies to dividends distributed from one SFC to another SFC after November 2, 2017, and before December 31, 2017, outside the ordinary course of business, notwithstanding that such dividends between SFCs are generally respected for purposes of determining accumulated post-1986 deferred foreign income pursuant to the statute. 
  • Per Se Reduction Principal Purpose: An E&P Reduction Transaction will be treated per se as being undertaken with a Reduction Principal Purpose if it involves one or more of the following: (i) a complete liquidation of an SFC under section 331; (ii) a sale or other disposition of stock by an SFC, or (iii) a distribution by an SFC that reduces the E&P of such SFC pursuant to section 312(a)(3) (a Specified E&P Reduction Transaction).
  • Pro Rata Share Transactions: A transfer of the stock of an SFC to a United States shareholder of the SFC or a person related to a United States shareholder of such SFC will be presumed to be undertaken with a Reduction Principal Purpose if such transfer would otherwise (i) reduce such United States shareholder’s pro rata share of the section 965(a) earnings amount of such SFC if it is a deferred foreign income corporation (DFIC); (ii) increase such United States shareholder’s pro rata share of the specified E&P deficit of such SFC if it is an E&P deficit foreign corporation; or (iii) reduce such United States shareholder’s pro rata share of the cash position of such SFC (a Pro Rata Share Transaction).
  • Per Se Reduction Principal Purpose: A pro rata share transaction will be treated per se as being undertaken with a Reduction Principal Purpose if, immediately before or after the transfer, the transferor of the stock of the SFC and the transferee of such stock are members of an affiliated group in which the United States shareholder is a member. 
  • Rebuttal: These presumptions, where applicable, may be rebutted only if facts and circumstances clearly establish that the transaction was not undertaken with a Reduction Principal Purpose. A taxpayer taking the position that the presumption is rebutted must include a statement with its relevant tax return to that effect.
  • Accounting Method Changes: Any change in method of accounting made for a taxable year of an SFC that ends in 2017 or 2018 will be disregarded for purposes of determining the 965 Liability of a United States shareholder if such change in method of accounting would otherwise reduce the 965 Liability of such United States shareholder and the request for the change was filed after November 2, 2017. It is important to note that these anti-avoidance regulations will not apply to any changes in methods of accounting in the event the taxpayer’s original and/or duplicate Form 3115, Application for Change in Accounting Method, was filed before November 2, 2017.
Eversheds Sutherland Observation: Not only does the Notice describe a potentially broad set of regulations, but there also may be a question about whether there is adequate authority to support the government’s determination that these changes in accounting method or entity classification may be “retroactively” disregarded using such a broad approach. Although the IRS has discretion regarding which changes in accounting method and entity classification may be approved, that discretion is not unlimited. Rather than apply its discretion about whether a particular change is proper, the IRS has issued a blanket determination that it will disregard any change in accounting method seeking to change a company’s E&P, thereby reducing its 965 Liability if the change was filed after a specified date. Producing a rather curious result, it appears that the same accounting method change may be respected to increase the 965 Liability of one United States shareholder while being ignored to prevent the reduction of the 965 Liability of another United States shareholder. Importantly, this prohibition is imposed regardless of whether the change is made with a principal purpose of reducing the 965 Liability of a United States shareholder. 
  • Entity Classification Elections: All entity classification elections filed on or after November 2, 2017 (even if effective prior to such date) will be disregarded for purposes of determining the 965 Liability if such election would otherwise reduce the 965 Liability of any United States shareholder.
  • The accounting method change and entity classification election rules apply regardless of whether the method change or classification election was undertaken with a Reduction Principal Purpose.

Other Rules

  • Accrual of Foreign Income Taxes: For purposes of determining an SFC’s post-1986 E&P as of the measurement date on November 2, 2017 (but not for the purpose of computation of foreign tax credits), any foreign income tax (as defined in section 901(m)(5)) that accrues (i) within the SFC’s US taxable year that includes November 2, 2017, and (ii) after November 2, 2017, but on or before December 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 US taxable year ending on November 2, 2017, and the part of the US taxable year beginning after November 2, 2017.
Eversheds Sutherland Observation: Notice 2018-07 provided guidance to avoid the double counting of post-1986 E&P arising from transactions between related specified foreign corporations of a United States shareholder that occurred between the measurement dates. Notice 2018-13 provided guidance that allowed taxpayers to determine an SFC’s post-1986 E&P as of November 2, 2017, by starting with the amount for October 31, 2017, and adding two days of E&P based on the proration.

This is a welcome relief, but there are other similar year-end expenses that relate to the entire year that the IRS has not yet addressed.

  • Partnership Constructive Ownership Rules: For purposes of determining whether a foreign corporation is an SFC, stock owned, directly or indirectly, by or for a partner will not be considered as being owned by a partnership through downward attribution if such partner owns less than 5% of the interests in the partnership’s capital and profits.
  • Cash Measurement Dates: The Cash Measurement Dates are modified, for purposes of determining the amount of cash and cash equivalents with respect to SFCs that go out of existence or are acquired or disposed of before the close of the last taxable year of such SFC that begins before January 1, 2018. The modifications require the United States shareholder to take into account its pro rata share of the cash and cash equivalents of the SFC only for the cash measurement dates on which such United States shareholder qualifies as a United States shareholder of such SFC.
  • Clarification of Accounts Receivable and Accounts Payable Definition: For the purpose of section 965, “accounts receivables” and “accounts payables” defined in Notice 2018-3 only include such receivables or payables that have a term of less than one year.
  • Documentation of Cash Position: The IRS intends to issue forms, publications, and regulations specifying the documentation that a United States shareholder must maintain to document its cash position, as well as guidance related to the time and manner for providing such documentation. 
  • Domestic Pass-Through Entities and Determination of Net Tax Liability: If a domestic pass-through entity is a United States shareholder of a DFIC, the section 965(a) inclusion or deduction amount should be determined at the level of the domestic pass-through entity, regardless of whether such domestic pass-through owner is also a United States shareholder of that DFIC. Furthermore, a domestic pass-through owner will be permitted to make specified elections, regardless of whether the domestic pass-through owner is itself a United States shareholder of a DFIC, and the domestic pass-through owner will be treated as a United States shareholder for purposes of determining its 965 Liability.
  • Application of Section 965(n) to Losses: If an election is made under section 965(n) with respect to a taxable year in which the inclusion year of a DFIC ends, the amount of a net operating loss carried back or forward to such year and the amount of a net operating loss generated for such taxable year will be determined without taking into account income related to the inclusion under section 965.
  • Underpayment Penalty Relief: The IRS will waive estimated tax underpayment penalties with respect to a taxpayer’s net tax liability under section 965. In addition, the IRS has determined that if the amendments to section 965 or section 958(b) under the Act cause an underpayment related to a required installment of estimated tax due on or before January 15, 2018, the estimated tax penalty will not apply to that underpayment.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Eversheds Sutherland (US) LLP | Attorney Advertising

Written by:

Eversheds Sutherland (US) LLP
Contact
more
less

Eversheds Sutherland (US) LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.