By now I suspect many of my readers have heard about (and are shedding tears over) new Internal Revenue Code Section 965, and the “deemed repatriation” or “transition tax” introduced by the Tax Cuts and Jobs Act (“TCJA”). My earlier blog post provided significant detail about this new tax law provision which is intended to move the US international tax regime into a “territorial system”. In making the transition, US shareholders of certain foreign corporations, referred to as “deferred foreign income corporations” (DFICs) must pay a one-time “deemed repatriation tax” on the past earnings that have been accumulating over the years in the foreign corporation.
A US person (e.g., a US citizen, green card holder; any US entity) that owns (or is “considered as owning” under certain constructive ownership rules) 10% or more of the DFIC (by vote or value) will have to pay the tax. This so-called “US shareholder” will pay the tax on the shareholder’s pro rata share of certain retained earnings and profits (E&P) of the foreign corporation. Generally, the tax applies to the corporation’s accumulated E&P (as computed using US tax rules) that have accumulated since 1986. Specifically, the E&P measurement date is the greater of the E&P balance as of November 2, 2017 or, as of December 31, 2017 unless an alternative date is elected.
Retiring? Not so Fast! You Might be Penniless
A US shareholder of a so-called “controlled foreign corporation” (CFC) will be right in the cross-hairs of this new tax. Tax professionals seem to be looking at all sorts of structures to determine if the transition tax might apply to it. In fact, I was surprised to read that one group believes the tax may apply to certain Australian Superannuation schemes. In my view, one has to be very careful with such analyses, lest unintended targets get drawn into the transition tax maze.
Speaking of having funds for retirement, read this post by attorney John Richardson. John explains that many US persons living in Canada use Canadian corporations as a kind of retirement vehicle. In most cases, these corporations will qualify as CFCs; the earnings that had previously accumulated tax-free for retirement will now be hit with the “transition tax”. For US persons who are subject ONLY to the US tax system (and not the tax system of another country, e.g., Canada) John explains that the “transition tax” is not a bad thing. For US persons living in another country, however, the tax can be a terrible thing, which may destroy their retirements. The reason is that US persons abroad can be subject to both US taxation (by virtue of the “transition tax”) and then taxation again in their countries of residence when the funds are later paid out to the individual.
When Must the Piper Be Paid?
When the transition tax is due depends, in part, on the tax year in which the US shareholder is deemed to receive the income. If the foreign corporation’s tax year ends on December 31, 2017, an individual US shareholder must report the deemed repatriated income on the 2017 US income tax return, Form 1040. The Form 1040 is due April 17, 2018 and even though the individual living abroad may have an automatic extension to file the tax return by June 15, 2018, this extension to file is not an extension of the time to pay the tax.
Time is at a premium. Many tax return preparers are swamped with the extra work involved in making the difficult calculations required in computing this tax.
A US shareholder of a foreign corporation with a fiscal tax year ending in the period between January 1 and before December 31, 2017, will have until the due date of the calendar year 2018 US tax return to report the deemed income.
IRS FAQs – How to Pay the Transition Tax
On March 13, the Internal Revenue Service (IRS) issued a series of FAQs about the new tax including instructions about how a taxpayer should pay the transition tax for a 2017 tax return. Failure to submit tax returns according to the instructions may result in difficulties in processing tax returns, including rejection, processing delays, or erroneous notices being issued. Taxpayers who electronically file Form 1040 are requested to wait to file their return on or after April 2, 2018 in order to provide the IRS time to make certain system changes to allow the returns to be accepted and processed.
The FAQs provide significant detail, including how to report Code Section 965 income and how to report and pay the transition tax.
The information also provides details about various elections that can be made by the taxpayer. Any election with respect to Code Section 965 must be made by the due date (including extensions) for filing the tax return for the relevant year.
An election can be made to pay the transition tax over eight years pursuant to Code section 965(h). Even if an election is made to pay the tax in installments, the first installment must be paid by the due date (without extensions) for filing the return for the relevant year.
Shareholders that are S corporations have an alternative option. An S corporation shareholder may elect to defer payment of the transition tax until there’s a so-called “triggering event”. Triggering events occur when the S corporation ceases to have S corporation status or when the corporation goes out of existence; upon a liquidation or sale of substantially all of the S corporation’s assets; upon a transfer of any of the S corporation’s shares by sale, reason of the shareholder’s death, or otherwise. Once a triggering event occurs, the shareholder may make the election to pay the transition tax over eight years, beginning in the year of the triggering event.
According to FAQ 10, with respect to the 2017 tax return, a taxpayer should make two separate payments: one payment should reflect the tax owed without regard to IRC Section 965, and a second, separate payment should be made reflecting the tax owed as a result of the new tax under Section 965. Both payments must be paid by the due date of the applicable return (without extensions).
Game Over – No Accounting Change Permitted that Could Alter Impact of the Tax
Generally, a taxpayer wishing to change its annual accounting period and use a new tax year must first obtain approval from the IRS and generally, this approval entails the taxpayer’s agreement to various IRS terms, conditions and adjustments. See Form 1128, Application To Adopt, Change, or Retain a Tax Year.
The IRS is on top of the game and immediately recognized how an accounting change could result in the avoidance, reduction, or delay in payment of the transition tax. The IRS noted: “[If a DFIC] with the calendar year as its taxable year elected, effective for its taxable year beginning January 1, 2017, a taxable year closing on November 30, the election could defer by as much as 11 months a United States shareholder’s inclusion with respect to the DFIC under Section 965. Further, the election could, depending on the facts, reduce the amount of the tax liability of a United States shareholder of the DFIC by reason of Sec. 965, including through the reduction of the post-1986 earnings and profits of the DFIC.”
Let’s take a concrete example of what the IRS is talking about. It the DFIC’s taxable year ends before December 31, 2017, e.g., November 30, 2017, its next taxable year would have begun on December 1, 2017, which is before January 1, 2018. In such a case, the deferred foreign income would be included in the US shareholder’s 2018 income tax return, due on April 15, 2019 for calendar year taxpayers. Nice deferral!
As a consequence, the IRS modified the circumstances under which it will approve requests for changes in annual accounting periods made by certain foreign corporations in 2017. With the issuance of Revenue Procedure 2018-17, the IRS position is clear – no approval will be given to any change to the annual accounting periods of DFICs having an annual accounting period that ends on December 31, 2017, if the change could result in the avoidance, reduction, or delay of the transition tax. This procedure will apply to any request to change an annual accounting period that ends on December 31, 2017, regardless of when the request was filed.
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