An Overview of IRC Section 965
An Overview of IRC Section 965
The transition tax (also referred to as mandatory repatriation) was imposed by the new U.S. tax law in IRC Section 965. The U.S. Department of Treasury and the Internal Revenue Service (IRS) have been busy in issuing guidance to taxpayers on how to deal with the transition tax and are currently working on regulations that are supposed to address many critical issues and unresolved areas of the new tax provision. Recently, the IRS has released a list of Frequently Asked Questions (FAQs) with respect to the transition tax imposed under IRC Section 965. This information pertains to the tax payment obligations and return filing deadlines, as well as other areas relevant to reporting the transition tax on one’s individual income tax return for the 2017 and 2018 tax years, as applicable.
Generally, pursuant to IRC Section 965, certain U.S. shareholders of certain foreign corporations are subject to the transition tax on positive post-1986 accumulated earnings and profits of such foreign corporations (Specified Foreign Corporations). A U.S. Shareholder is any U.S. person who holds at least 10 percent of a foreign corporation stock by vote (that definition was expanded from the 2018 tax years to include vote or value). The Specified Foreign Corporation (SFC) is defined as a Controlled Foreign Corporation (a foreign corporation where U.S. Shareholders own more than 50 percent by vote or value) or a foreign corporation that has at least one U.S. domestic corporation as a U.S. Shareholder, even if the foreign corporation is not a CFC. The transition tax has retroactive effect on most individual U.S. Shareholders.
Only positive post-1986 earnings and profits of SFCs are subject to the transition tax. To the extent a SFC has earnings and profits deficit, U.S. Shareholders of that SFC would not be subject to the transition tax. Pursuant to IRC Section 965, the positive earnings and profits of one SFC can be offset by a deficit in another SFC owned by the taxpayer.
The transition tax is punitive for many U.S. persons who live and work outside the United States. There are limited tax planning opportunities, the calculation of the transition tax is complex, and several areas have lots of uncertainty.
The Questions and Answers section below is based on and is prepared pursuant to the IRS FAQ About Reporting Related to Section 965 on 2017 Tax Returns (available at: https://www.irs.gov/newsroom/questions-and-answers-about-reporting-related-to-section-965-on-2017-tax-returns) (last visited June 1, 2018). Where feasible, some explanations / term definitions are added.
Q1: Who is required to report Internal Revenue Code (IRC) Section 965 amounts on their 2017 U.S. tax return?
A U.S. Shareholder of a Deferred Foreign Income Corporation (DFIC), as well as a direct or indirect partner in a U.S. partnership, a shareholder of an S corporation, or a beneficiary of another passthrough entity that is a U.S. shareholder of a DFIC are subject to reporting under IRC Section 965.
Note that U.S. Shareholder is defined as any U.S. person that owns (directly, indirectly, or constructively) 10 percent or more of the voting stock in a foreign corporation. Note that for the tax years of foreign corporations beginning after January 1, 2018, an expanded definition of the U.S. Shareholder applies. The term “U.S. person” includes individuals and entities.
DFIC is any Specified Foreign Corporation (SFC) that has accumulated post-1986 deferred foreign income (based on positive earnings and profits) as of November 2, 2017 or December 31, 2017.
SFC generally includes Controlled Foreign Corporations (CFCs) (more than 50 percent ownership by vote or value is required by U.S. Shareholders) and any foreign corporations where a U.S. corporation has at least 10 percent ownership interest.
The IRS provided a detailed chart showing how the IRC Section 965 amounts should be reported on U.S. Shareholders’ tax returns. Generally, the transition tax should be reported separately from the taxpayer’s otherwise applicable U.S. tax liability. In addition, the IRS requires attaching an IRC 965 Transition Tax Statement to be attached to the 2017 return.
Yes. If an individual is required to report an IRC Section 965 amount on their 2017 U.S. income tax return, they are also required to include an IRC 965 Transition Tax Statement. The statement can be filed in paper, attached to the 2017 income tax return, or filed electronically in PDF format (.pdf), attached to your e-filed return with a file name of “965 Tax”. If more than one Transition Tax Statement are attached, they all can be combined into a single .pdf file. Importantly, the statement must be signed under penalties of perjury.
The IRS requires the taxpayer to maintain proper records supporting the calculations made on the Transition Tax Statement. These amounts and associated calculations will be used in subsequent reporting years, even as the method of reporting will likely change based on modified instructions to other information reporting filings such as Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations .
The IRS provides a sample statement on its website. The sample can be replaced by any statement that does not necessarily mirror the sample statement, as long as the Transition Tax Statement contains the following information:
- The amount of income included under IRC Section 965;
- The taxpayer’s aggregate foreign cash position [a defined term under IRC Section 965(c)(3)], if it applies to the taxpayer;
- The deduction amount claimed under IRC Section 965(c);
- The taxpayer’s deemed paid foreign taxes with respect to the total amount required to be included in income;
- The taxpayer’s disallowed foreign tax credits under IRC Section 965(g);
- The Taxpayer’s total net tax liability under IRC Section 965;
- The amount of the net tax liability under an election to pay the liability in installments IRC Section 965;
- The amount of the net tax liability under the special provisions for S corporations, the payment of which has been deferred;
- A list of the applicable elections made by the taxpayer, which was provided for in IRS Notice 2018-13. The sample statement provided by the IRS asks whether or not an election was made and whether a subsequent attachment is attached to the tax return. If you are creating your own statement, indicate that an election was made and whether an attachment is included in the filing.
There are various elections that can be made with respect to the income included on a 2017 U.S. tax return pursuant to IRC Section 965, including:
- Election to pay tax liability arising as a result of the IRC Section 965 inclusion in eight backloaded installments;
- Election to pay deferred S corporation shareholder net tax liability in installments;
- Election to defer inclusion of IRC Section 965 amounts by Real Estate Investment Trusts (REITs);
- Election Not to Apply Net Operating Loss (NOL) deduction;
- Election to Use Alternative Method to Compute Post-1986 Earnings and Profits Under Section 3.02 of Notice 2018-13.
Q5: Who is able to make an election pursuant to IRC Section 965 on their 2017 U.S. income tax return?
The following persons are eligible to make an election as per IRC Section 965 of the Code:
- Taxpayers who have a net tax liability pursuant to IRC Section 965(h);
- Taxpayers who have a net tax liability and are shareholders of S corporations pursuant to IRC Section 965(i);
- Taxpayers who are REITs (Real Estate Investment Trusts) pursuant to IRC Section 965(m);
- Taxpayers with a NOL (Net Operating Loss) pursuant to IRC Section 965(n).
A domestic partnership or an S corporation that is a U.S. shareholder of a DFIC may not make any of the elections under IRC Section 965. IRS Notice 2018-26, section 3.05(b) provides further information about applicable elections for direct and indirect partners in U.S. partnerships, shareholders of S corporations and beneficiaries in other passthrough entities that are U.S. Shareholders of DFICs. Treas. Reg. §1.964-1(c)(3) and IRS Notice 2018-13, Section 3.02 discuss how an election can be made on behalf of an SFC.
The IRC Section 965 election must be made by the due date (including extensions) for filing the income tax return for the relevant tax year. For an election to pay net tax liability in installments the first installment must be paid by the due date (without extensions) for filing the return for the relevant tax year.
The election is made by attaching a statement, signed under penalties of perjury, to a 2017 U.S. income tax return. Note that all elections must be accompanied by a separate IRC Section 965 statement relevant to the particular election being made by the taxpayer. In case of an e-filed return, the Taxpayer must attach a PDF for any election (see Answer 3 above).
For example, the election to pay net tax liability in installments would include the anticipated installment payment schedule and the net tax liability that is eligible for installment payments. The election to defer payment of net tax liability for a S corporation shareholder would include the name of the S corporation, the tax identification number of the S corporation, and the net tax liability. The Statement for Real Estate Investment Trusts Electing Deferred Inclusions would include the anticipated installment schedule. The Election Not to Apply Net Operating Loss Deduction would include the amount to be taken into account for the deduction and the taxes deemed to be paid by the corporation. The election to use the Alternative Method to Compute Post-1986 Earnings and Profits who include the name of the SFC, the corporation’s taxpayer identification number and reference to IRS Notice 2018-03.
Q8: Is Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations with respect to all SFCs to which a taxpayer is a U.S. Shareholder, required to be filed with the taxpayer’s 2017 tax return, regardless of the status of the SFC as a Controlled Foreign Corporation?
Yes. Form 5471 is an international information return and is required to be filed, even if an SFC is not a CFC because it provides the IRS with the information used to:
- Calculate the U.S. Shareholder’s IRC Section 965 inclusion amount;
- Determine if the taxpayer was a U.S. Shareholder of a SFC during the SFC’s 2017 tax year or on the last day of such year, and owned stock of the SFC on the last day of the SFC’s year that ended during the taxpayer’s year.
The taxpayers must complete the identifying information on page 1 of Form 5471 above Schedule A, as well as Schedule J.
There are exceptions to filing Form 5471 that continue to apply. Please refer to the instructions to Form 5471 to determine which exceptions may be relevant to your case. You can find the form here: https://www.irs.gov/forms-instructions. U.S. Shareholders who are not otherwise under the obligation to file Form 5471, must review the instructions to determine their tax filing category.
The IRS and the Department of Treasury announced in Notice 2018-13, section 5.02, that they intend on issuing regulations to provide relief from filing of Form 5471 for those taxpayers who are considered to own stock in foreign corporations by “downward attribution” due to the repeal of IRC Section 958(b)(4).
Q9: What are the IRC Section 965 reporting requirements for partners, shareholders, or beneficiaries of U.S. partnerships, S corporations and other pass through entities?
Schedule K-1, which is used to report each shareholder’s share of income, losses, deductions and credits and subsequently used by the shareholders to report this information on their tax return, should also include a separate statement, attached, for each DFIC for which such passthrough entity has an IRC Section 965(a) inclusion amount. The following information should be included on Schedule K-1:
- The partner’s, shareholder’s, or beneficiary’s share of the partnership’s, S corporation’s, or other passthrough entity’s IRC Section 965(a) inclusion amount, if applicable;
- the deduction amount under IRC Section 965(c), if applicable; and
- information necessary to compute the deemed paid foreign tax credit for the IRC Section 965(a) inclusion amount for a U.S. corporate shareholder or an individual U.S. Shareholder making an election under IRC Section 962 to be treated as a corporation. IRS Notice 2018-26, Section 3.05(b) provides further information related to the application of IRC Section 965 for the entities listed above.
The tax is paid via wire transfer, check or money order. Taxpayers that would normally be required to pay through the Electronic Federal Tax Payment System provided by the U.S. Department of Treasury should submit the IRC Section 965 payment via wire transfer or they may be subject to penalties. Please refer to the specific procedure for using wire payment or check or money order payment as there is a specific tax code number and/or information to write on the form of the payment.
There are two separate payments that are made with respect to a taxpayer’s 2017 income tax return and IRC Section 965. One payment is with respect to tax owed without taking into account IRC Section 965 and the other is a separate payment made with regards to the tax owed from IRC Section 965 that is not otherwise satisfied by a payment or credit. If the taxpayer receives an extension of time to file pursuant to Treasury Regulations §1.6081-5(a)(5) or (6), the taxpayer’s due date for the IRC Section 965 payment is also extended. Otherwise, both payments must be paid by the due date of the applicable return, without extensions.
Q11: If an individual has not already filed their 2017 U.S. income tax return via electronic filing, when should the return be filed?
Electronic filers should file on or after April 2, 2018. Taxpayers who file via paper are required to file before the due date of their applicable return.
Q13: How will the IRS apply 2017 estimated tax payments (including crediting overpayments from 2016) to a taxpayer’s net tax liability under IRC Section 965?
The IRS will apply 2017 estimated tax payments to a taxpayer’s 2017 net income tax liability without regard to IRC Section 965 and without regard to any income or deduction properly attributable to a dividend received by such U.S. shareholder from any DFIC. The remaining estimated tax payments will then be applied to the tax liability that arose from the IRC Section 965 calculation, including amounts subject to installment payments with the relevant election.
Q14: If a taxpayer’s 2017 payments, including estimated tax payments, exceed its 2017 net income tax liability determined without regard to IRC Section 965 and the first annual installment, which was due in 2018, pursuant to an election under IRC Section 965(h), may the taxpayer receive a refund of any excess amounts or credits for these amounts to its 2018 estimated income tax?
No. A taxpayer may not receive a refund or credit of any portion of properly applied 2017 tax payments unless and until the amount of payments exceeds the entire unpaid 2017 income tax liability, including all amounts to be paid in installments in subsequent years. If a taxpayer’s 2017 tax payments exceed the 2017 net income tax liability, determined without regard to IRC Section 965 and the first annual installment, which is due in 2018, pursuant to an election under IRC Section 965(h), the excess will be applied to the next successive annual installment, which would due the following year in 2019. This would continue to annual installment due in the following year of 2020 and beyond.
Q15: What should I do if I am uncertain how IRC Section 965 applies to me and/or am unable to do the relevant calculations myself?
Engage the services of a qualified U.S. tax professional who is comfortable with the new legislation and its application.
Q16: What is the 2017 filing deadline for U.S. citizens and Green card holders who live in Canada and otherwise outside the United States?
The filing deadline and the tax payment deadline is June 15, 2018, provided certain requirements are met. An extension till October 15, 2018 is available by filing Form 4868, but the tax payment deadline cannot be extended.