As most of my readers are no doubt aware, The Tax Cuts and Jobs Act (“TCJA”) heralded numerous changes to the US tax law. One of TCJA’s changes implemented new Internal Revenue Code Section 965, bringing the “deemed repatriation” or “transition tax” to the table. This new provision is intended to help convert the US international tax system into what is called a “territorial system”, with the goal being to enhance the US as a jurisdiction to do business in such a way that US corporations will not be taxed when receiving future distributions of profits from their overseas subsidiaries. In “transitioning” to this new model of taxation, US shareholders of certain foreign corporations must pay a one-time “deemed repatriation tax” on the past earnings that have been accumulating over the years by the foreign corporations in which they hold shares. Because the tax is a “deemed” tax, it will apply even though the earnings are not actually distributed to the US shareholder (note, however, that no tax will again be due when the earnings are actually paid out to the shareholder).
Who Takes the Tax Hit?
Any “US shareholder” of a so-called “specified foreign corporation” will take the tax hit. Generally, a “US Shareholder” is any US person (think, US citizen, green card holder or US tax resident due to prolonged physical presence in the USA, or any US entity) who owns (or is “considered as owning” pursuant to highly complex constructive ownership rules) 10% or more of the corporation (by vote or value).
A “specified foreign corporation” is:
1) Any “controlled foreign corporation“ (CFC), or
2) Any foreign corporation which has one or more domestic (US) corporations which are US shareholders, regardless of whether that foreign corporation is a CFC.
If a PFIC is not a CFC, then the PFIC is not a “specified foreign corporation”.
What Happens? How is the Tax Calculated?
The effect of the transition tax is to tax the US shareholder on the shareholder’s pro rata share of certain retained earnings of the foreign corporation. Generally, the tax applies to accumulated earnings and profits (E&P) of the corporation (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 pursuant to IRS Notice 2018-13. Glossing over the complexity, I will add that certain exceptions apply in making the calculations (for example, income that has been previously taxed under Subpart F is not included) and special rules must be considered in certain cases (e.g., when there are at least two specified foreign corporations, and at least one of them has positive retained earnings, and one or more of the others has a deficit in retained earnings), as well as special (confusing and illogical) treatment when figuring foreign tax credits.
Once the E&P of the corporation accumulated since 1986 has been calculated and the taxpayer’s pro rata share determined, the tax rate to the shareholder must be ascertained. This is determined pursuant to a rather complex formula contained in the new Code Section 965. The rates of tax differ if the E&P is attributable to cash/cash equivalents (taxed at a rate of 15.5%) versus fixed assets (taxed at a rate of 8%). It has been estimated that these rates will apply to approximately $3.1 trillion in earnings that have been “stockpiled” overseas since 1986.
Absent making a special election, the tax rate imposed on individual shareholders could be significantly higher than the tax rate imposed on corporate shareholders, but the intent seems to be that individual and corporate shareholders should be treated the same in this respect. Joint Explanatory Statement of the Committee of Conference at page 491 (emphasis added):
“As a result, the total deduction from the amount of the section 951 inclusion is the amount necessary to result in a 15.5-percent rate of tax on accumulated post-1986 foreign earnings held in the form of cash or cash equivalents, and 8-percent rate of tax on all other earnings. The calculation is based on the highest rate of tax applicable to corporations in the taxable year of inclusion, even if the U.S. shareholder is an individual. The use of rate equivalent percentages is intended to ensure that the rates of tax imposed on the deferred foreign income is similar for all U.S. shareholders, regardless of the year in which section 965 gives rise to an income inclusion. Individual U.S. shareholders, and the investors in U.S. shareholders that are pass-through entities generally can elect corporate rates [per Code Section 962] for the year of inclusion.”
Assuming the maximum tax rates and not making the election under Code Section 962, the tax rate to an individual shareholder would be 17.54% (15.5% for a corporate shareholder) on income held by the corporation as cash and cash equivalents and approximately 9.05% (8% for a corporate shareholder) on the corporation’s illiquid (e.g., fixed) assets.
When is the Tax Due?
When the 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.
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. It should be noted that foreign corporations cannot change their tax year in order to defer the tax. A CFC with a fiscal tax year may in fact be required to change its tax year to a calendar year following the year of the deemed income inclusion.
The one-time tax can be paid either as a lump-sum or in installments spread out over eight years if a special election is timely made. If the installment method is chosen, the amount that must be paid for each of the first 5 years is 8% of the tax due. For years 6, 7 and 8, the amounts due are 15%, 20% and 25%, respectively.
The IRS has issued various Notices providing guidance on the transition tax. All of these Notices can be found here.
The Silver Lining: Expatriation Just Got Easier For Some
For US persons (citizens and certain green card holders) who are interested in relinquishing their US status, the deemed repatriation tax may be a blessing in disguise. The tax due under the new rules will certainly reduce the individual’s net worth. It could possibly bring the individual’s net worth dollar number under the US$2 million threshold for application of the US expatriation regime (e.g., the exit tax and Section 2801 transfer taxes). For those sitting on the fence who are now completely fed up with the US tax regime it may be the perfect time to exit.
Appropriate tax advice should be taken along with a complete analysis of net worth for those US persons impacted by the deemed repatriation tax. If the decision to relinquish US status is taken, then the installment method of paying the one-time repatriation tax cannot be used since the individual’s US tax obligations must be fully satisfied prior to expatriation.
Expatriation is complicated; it is not a decision to be taken lightly. Everything you ever wanted to know about the US tax issues associated with expatriation can be found here. Interestingly enough, the total number of expatriates as reported by the IRS for 2017 was 5,133 individuals, a 5% drop since last year’s number (2016 had 5,411 IRS-published expatriates). Surprisingly, 2017 was the first year since 2012 with a year-over-year decrease in the number of individuals giving up their US status. The methods used by the IRS to compile expatriation data is discussed at length by Andrew Mitchel and Ryan E. Dunn here. I suspect with the new tax law, we will see these numbers rising once again.
Finally, I take this opportunity to thank both Ali Khan, CPA and John Richardson for their input on today’s blog post. I appreciate the professional exchange with all of my tax colleagues in coming to grips with TCJA!
All the US tax information you need, every week — Just follow me on Twitter @VLJeker (listed in Forbes, Top 100 Must-Follow Tax Twitter Accounts 2017 and 2018)
This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute tax advice or a recommended course of action. Professional tax advice should be sought as the information here is not intended to be, and should not be, relied upon by the recipient in making a decision.