International Tax Reform 4.0 – Transition Tax on Foreign Earnings – New Guidance

In Notice 2018-07 (“Notice”), the IRS has moved quickly to provide preliminary guidance under Internal Revenue Code Section (“§”) 965, as amended by “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018,” P.L. 115-97, enacted on December 22, 2017. We’re impressed by the quick information release. As we’ve stated, the IRS is under pressure to release guidance so taxpayers and their advisors can attempt to comply with the new complexities in the entire tax law, not just in the international provisions.


This Notice should remind taxpayers to take practical next steps related not only to §965 but also to distributions in general. Our experience tells us many taxpayers do not accurately track E&P, whether in domestic or foreign companies. The typical context is a tax advisor receiving the following plea for help in a call or email — Our company just distributed $2M to the owners, and now the President / Treasurer / Board (take your pick) is asking about the tax implications. Ignore for a minute that if the company is foreign there are a multitude of other issues (e.g., whether foreign law labels the distribution a dividend versus a return of capital versus something else does not dictate US tax treatment; whether the US parent confirmed the funds legally could be distributed; whether there are foreign currency controls and / or whether anyone checked potential foreign currency gain / loss; etc.), from a pure US-centric posture, was anyone accurately tracking E&P? This is essential both to designing planning strategies and complying in general. Without an E&P calculation, how do you know the amount of a distribution that is a dividend? A return of capital? A capital gain? What potentially creditable foreign taxes are involved? How to defend your position on an IRS or state tax authority audit? Whether any of the distribution is tax-free because it was already taxed via the complex anti-deferral rules? [Note: The anti-deferral rules were not eliminated under the new law, nor were they simplified as a whole given the lack of attention to the look-through rule.]


You should have a bit of background before reading the Notice. For those of you who may have enjoyed your vacation time instead of reading the new law, the new law provides that US companies don’t pay tax on certain foreign dividends. More specifically, new §245A allows USCos owning at least 10% of a specified foreign corporation to claim a 100% dividends received deduction on the foreign-source portion of the dividend. Amended §965 includes a price tag for the tax benefit: a transition tax in which a foreign corporation’s E&P becomes taxable to the US owner at 15.5% or 8%, depending on the nature of the earnings. Feel free to see our prior blogs for more background – .


The Notice focuses on several areas. Section 2 is essentially a regurgitation of §965 but, frankly, it’s nice to read it in complete sentences without all the section headings and subheadings. Section 3 provides several examples calculating the foreign cash position and guidance on allocating between multiple inclusion years. [See the example in 3.01.a., first paragraph, for the most basic item.] This is helpful to ensure no cash double-counting and, therefore, no over-stating taxable income. There is also helpful clarification on the treatment of related-party transactions to determine the cash position, and therefore the US tax rate on the income. (See 3.01.b.) Specifically:


Net accounts receivables and short-term obligations between related specified foreign corporations may inflate the aggregate foreign cash position of a United States shareholder relative to the actual aggregate amount of liquid assets (other than the intercompany receivables) owned by the specified foreign corporations of the United States shareholder. For example, if a United States shareholder wholly owns two specified foreign corporations and one specified foreign corporation makes a short-term loan to the other specified foreign corporation, the borrowing corporation may invest the proceeds of such financing in illiquid assets or may spend the cash on operating expenses. The resulting intercompany receivable would be included in the United States shareholder’s aggregate foreign cash position, notwithstanding that, if the specified foreign corporations were treated as a single corporation, the liquid assets of the specified foreign corporations would have been reduced by the amount of the borrowed proceeds.


Accordingly, for purposes of determining the cash position of a specified foreign corporation with respect to net accounts receivable and short-term obligations, the Treasury Department and the IRS intend to issue regulations providing that, with respect to a United States shareholder, any receivable or payable of a specified foreign corporation from or to a related specified foreign corporation will be disregarded to the extent of the common ownership of such specified foreign corporations by the United States shareholder. For this purpose, a specified foreign corporation will be treated as related to another specified foreign corporation to the extent that the specified foreign corporations are related persons within the meaning of section 954(d)(3), substituting the term “specified foreign corporation” for “controlled foreign corporation” in each place that it appears.


3.01.c. focuses on the treatment of derivative financial instruments while 3.02 provides several examples on E&P adjustments. The 3.02 examples attempt to ensure no double-counting or double non-counting, to ensure an equitable tax result. However, they also illustrate the complexity that taxpayers and their advisors will face in attempting to comply with the law. The examples focus on a US Parent company owning CFC 1 which owns CFC 2 and track a combination of income / expense / distribution items, some between the related parties, and applying the November 2 versus December 31 measurement dates to calculate the correct income taxable in the US. In Example 1, a deductible payment from CFC 2 to CFC 1 creates a mismatch between the E&P at the two measurement dates under the statutory calculation so that total E&P might exceed the aggregate economic profit. The Notice states the regulations to be issued by the Treasury Department and the IRS would adjust the mechanical calculation to confirm what we believe to be a common sense answer (but one that would be incorrect on a technical read of the statute without the regulations).


Example 2 includes a distribution from CFC 2 to CFC 1 and has a similar E&P adjustment for a common sense result. However, the reasoning is different as the law treats distributions between specified foreign corporations differently from deductible payments.


In Example 3, CFC 2 accrues unrelated party gross income and CFC 1 incurs unrelated party deductible expense. The regulations will not adjust the relevant earnings for §965 as they don’t arise from an amount paid or incurred between related specified foreign corporations. Here, while the net economic income doesn’t change, the US taxable income can. Example 4 uses Example 3 as a base and adds a deductible payment by CFC 2 to CFC 1. It’s worth reviewing the differences in these four examples.


There are additional general clarifications in the following areas:


  1. E&P adjustment limitations for distributions to/from specified foreign corporations.
  2. Calculating E&P where there is a controlled foreign corporation (“CFC”) with non-US shareholders.
  3. Foreign currency gain/loss.
  4. Effective dates.
  5. Request for comments.
  6. Also — 3.02.d provides coordinating rules between §§959 and 965 and specific steps to determine the income inclusion under §965, the treatment of distributions under §959 and the amount of inclusion under §951(a)(1)(B) and §956 – and there’s an example that is worth plowing through.


First, the Subpart F income of the specified foreign corporation is determined without regard to 965(a), and the US shareholder’s inclusion under §951(a)(1)(A) by reason of such amount is taken into account. Second, the treatment of a distribution to another specified foreign corporation that is made before January 1, 2018 is determined under 959. Third, the 965(a)inclusion amount of the specified foreign corporation is determined, and the US shareholder’s inclusion under §951(a)(1)(A) by reason of such amount is taken into account. Fourth, the treatment of all distributions other than those described in step 2 is determined under 959. Fifth, an amount is determined under 956cwith respect to the specified foreign corporation and the US shareholder, and the US shareholder’s inclusion under §951(a)(1)(B) is taken into account.


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