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

by Eversheds Sutherland (US) LLP
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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.

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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.

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