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U.S. Transition Tax Regs Provide Clarity, Limited Relief

August 2, 2018
By Andre Velarde
Published in Tax Notes

Lengthy transition tax regs may offer practitioners some reassurance in fleshing out more details, but they don’t venture much outside the original scope of previous guidance.

“With the release of the regs, [there’s] not absolute certainty as to the transition tax liability, but [it’s] pretty close,” Jose Murillo of EY said.

The highly anticipated proposed regs (REG-104226-18), released August 1, are one of the first pieces of key guidance from the Tax Cuts and Jobs Act (P.L. 115-97) to be released.

Practitioners had been anxiously awaiting more guidance on the transition tax because three previous notices, while detailed, left many questions unanswered. The 249-page reg package is divided into nine sections, including rules on adjustments to earnings and profits and basis, determining section 965(c) deductions, disregarding some transactions, foreign tax credits, elections and payments, and affiliated groups.

“Despite their length, the proposed regulations do not break new ground compared to the previous notices,” John L. Harrington of Dentons said, noting that the rules generally rejected comments to relax the rules set forth under section 965 and notices. “On one level that is disappointing, but these proposed regulations are being released after the due date for the first payment of section 965 tax liability and with only a little more than two months before the deadline for those who obtained an extension. So it was probably unrealistic to expect IRS and Treasury to make significant changes to the rules previously announced in the notices and Q&As.”

As part of a move to a participation exemption system, the TCJA enacted a transition tax on accumulated offshore earnings of multinationals at a 15.5 percent rate for cash holdings and an 8 percent rate for other assets. Taxpayers may also elect to pay the tax in eight annual installments.

“You hope for clarity, and you pray for relief. There’s a little bit of both — probably more on the clarity side,” Robert Russell of Alliantgroup LP said, noting that the added certainty provided by the regs was helpful.

Declining Relief

The proposed regs are frequently consistent with provisions previously enumerated in the notices, including as related to general rules and definitions. Specifically, this includes guidance related to defining or calculating post-1986 earnings and profits and accounting for hovering deficits, E&P deficit foreign corporations, accumulated post-1986 deferred foreign income, cash measurement dates, the treatment of derivative financial instruments, defining accounts receivable and payable, short-term obligations, and determining foreign currency translation.

Although nothing new stood out to Murillo, he said the regs address in detail many issues that had been flagged in the previous three notices to provide greater certainty toward the section 965 calculation.

According to Murillo, taxpayers had been hoping for favorable guidance from Treasury, though the government declined to provide it in many areas. He cited to determination of the amount subject to the transition tax when a taxpayer has foreign subsidiaries with previously taxed income (PTI) and non-PTI deficits. In some cases, PTIs, which a taxpayer would not pay transition tax on, were preventing the use of favorable E&P deficits, Murillo explained.

Commentators had asked that previously taxed E&P should be disregarded in determining a specified E&P deficit. But Treasury and the IRS declined to make that exclusion because it was not expressly made in section 965(d)(3), unlike the term “accumulated post-1986 deferred foreign income” in section 965(d)(2), which did explicitly exclude previously taxed E&P.

According to Russell, limited relief provided on the double counting of cash under prop. reg. section 1.965-3(b)(2), which provides details on how a taxpayer “can lay out their case” could be contrasted with a refusal by Treasury and the IRS to budge on cash counting for non-liquid cash.

“I’ve got [a taxpayer] that borrowed for a day for purchase of a foreign company, and that’s going to get swept up into the cash calculation,” Russell said. “[The regs] raise comments that came in about sympathetic situations, and they just said ‘we can’t go on a case-by-case basis. That’s no way to administer the tax code.’”

Murillo also pointed to Treasury’s refusal to provide relief on the determination of cash equivalents, in particular as related to positions in publicly traded subsidiaries that are not actively traded by the holder and to commodities that are inventory.

Murillo added that taxpayers had been hoping for favorable treatment of notional pooling used by multinationals to sweep cash between affiliates to net balances, but again, Treasury declined.

The proposed regs also refuse to adopt commentators’ calls that specified foreign corporations that are not a CFC be allowed to use an alternative measure for determining post-1986 E&P and cash position, such as financial statements. Commentators had argued that such entities do not generally track U.S. E&P.

“The Treasury Department and the IRS appreciate that obtaining accurate information for U.S. federal income tax purposes may present administrative challenges, particularly in the case of United States shareholders that do not have a majority interest in a specified foreign corporation,” the preamble states. “However, this challenge is not unique to this context; there are numerous longstanding provisions in the Code where minority shareholders of foreign corporations must determine E&P consistent with section 312 where no alternative measurement method is provided.” The preamble cites to passive foreign investment company rules and the need for minority shareholders to know the E&P of a CFC to apply subpart F.

All About That Basis

The proposed regs also address adjustments to basis by reason of section 965(b). Generally, there is no adjustment to basis of stock or property to account for the reduction to a section 958(a) U.S. shareholder’s pro rata share of the section 965(a) earnings amount of a deferred foreign income corporation (DFIC) under the reduction rules. Section 965(o) gives authority to write regs on basis adjustments though. The guidance notes that an increase to the basis of stock of DFICs is appropriate only if there is a corollary reduction to the basis of the stock of E&P deficit foreign corporations.

“However, the Treasury Department and the IRS recognize that such reduction, which could in certain cases give rise to gain, could be overly burdensome for taxpayers,” the preamble states.

The regs allow an election to make basis adjustments, which must be made consistently with all section 958(a) stock of specified foreign corporations. The adjustments are an increase in the section 958(a) U.S. shareholder’s basis in the section 958(a) stock of a DFIC equal to the section 965(b) previously taxed E&P of the DFIC for the section 958(a) U.S. shareholder, and a reduction in the section 958(a) U.S. shareholder’s basis in the section 958(a) stock of an E&P deficit foreign corporation for an E&P deficit foreign corporation by an amount equal to the portion of the section 958(a) U.S. shareholder’s pro rata share of the specified E&P.

Joseph Calianno of BDO USA LLP found the regs’ discussion on basis particularly noteworthy.

“They did provide some relief through an election,” Calianno said. “That is pretty significant because a lot of taxpayers were looking to [the IRS and Treasury] to address that issue.”

Murillo also considers the relief allowed through the shifting of basis significant, but he noted that it may be limited to specific fact patterns involving brother-sister entities directly owned by a

U.S. shareholder that involve both positive E&P and a deficit. The rule would not apply if the deficit is in the same chain of ownership but lower in the structure, he said.

“Some relief was expected because I don’t think Congress was intending to give you some relief upfront, but tax you on the back end,” Murillo said.

The regs reserve on rules for basis adjustments under section 962 elections.

Individual Elections

The proposed regs also provide some clarity related to individual taxpayers making a section 962 election. Practitioners had previously expressed concerns that individuals may end up paying more under section 965 than corporations.

Under section 962, U.S. individual shareholders may annually elect to be taxed at the corporate tax rate for their section 951(a) subpart F inclusions. The taxpayer may also claim the deemed- paid foreign tax credit under section 960. The election has its limits, however, because under section 962(d), when an actual distribution is made, the E&P from a CFC that exceed the tax applicable under the section 962 election are also treated as income.

Under the regs, for taxpayers making a section 962 election, the section 965(c) deduction, generally available to U.S. shareholders of DFICs, is allowed for the tax imposed under section 11 for corporations instead of section 1 for individuals. The regs also clarify that taxable income is not reduced by other amounts, including other deductions.

Since the participation exemption is based off the highest corporate tax rate, commentators requested guidance changing the application of the exemption to individuals. But the regs defer to Congress on that point, noting that the Conference Report anticipated individuals making a section 962 election.

“That footnote in the Committee Report, it was there yes, but it was more about existence of that code section. When you have it in practice and do the math on a return, the numbers don’t always get you there,” Russell said.

Antiavoidance Rules

The proposed regs also largely adopt antiavoidance rules previously laid out in Notice 2018-26, 2018-16 IRB 480. The preamble rejects comments that requested the antiavoidance rule to not apply if a reduction in tax liability under section 965 is offset by an equal amount of tax under a different part of the code.

“The Conference Report reflects an intent for the Treasury Department and the IRS to address all strategies for avoiding a section 965(a) inclusion, without regard to the effect on overall tax liability,” the preamble states. “It would be difficult for the IRS to determine whether a particular increase in tax liability for non-section 965 reasons is related to the reduction in the taxpayer’s section 965(a) inclusion.”

The preamble also rejects calls for a de minimis exception to the antiavoidance rule as inconsistent with congressional intent.

Foreign Tax Credit

Under the transition tax, no foreign tax credit is allowed under section 901 for the applicable percentage of taxes paid or accrued or treated as paid or accrued onto which the section 965(c) deduction amount is allowed.

Comments had requested clarification on the definition of “taxes paid or accrued” or “taxes treated as paid or accrued.” The proposed regs state that “taxes paid or accrued” applies to foreign income taxes paid or accrued directly under section 901, and “taxes treated as paid or accrued” includes foreign income taxes deemed paid under section 960, foreign income taxes allocated to an entity under reg. section 1.901-2(f)(4), and a distributive share of taxes paid by a partnership.

In clarifying “applicable percentage,” the preamble notes that if a U.S. shareholder has more than one section 958(a) U.S. shareholder inclusion year, there may be more than one applicable percentage from differing aggregate foreign cash positions. An owner of more than one domestic passthrough entity may also have different applicable percentages because of differing aggregate foreign cash positions and different applicable percentages regarding the person’s section 958(a) stock.

The proposed regs state that no deduction or credit is allowed for the applicable percentage of withholding taxes imposed on a U.S. shareholder for a distribution of section 965(a) previously taxed E&P or section 965(b) previously taxed E&P.

The guidance also provides that the credit allowed under section 960(a)(3) is only related to foreign income taxes imposed on an upper-tier foreign corporation on distributions of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits from a lower-tier foreign corporation.

Calianno noted that many of the foreign tax credit issues had been addressed previously, but the regs expand on several issues to offer greater clarity, including as related to the treatment of PTI. He said he did not find the guidance in the area surprising, however.

Installment Payments

While taxpayers may elect to pay the transition tax in installments, failure to timely pay an installment is an acceleration event for the remaining installments.

The proposed regs provide that if a deficiency is assessed, a person timely files a return increasing the amount of its section 965(h) net tax liability above the amount accounted for in the payment of the first installment, or the person files an amended return increasing its section 965(h) net tax liability, the deficiency or additional amount will be prorated among the installments.

The guidance also states that if a taxpayer makes a section 965(h) election and does not pay the correct amount for the first installment, and there is proration, the remaining installment payments due under the section 965(h) election will not be accelerated and the taxpayer’s section 965(h) election will not be affected.

Harrington found the clarification surrounding underpayment of the first installment payment particularly helpful.

“The previous notices and guidance had addressed audits but not self-correcting by the taxpayer on a return filed after the first installment. The proposed regulation’s approach of prorating the underpayment is a more sensible approach than invalidating the election,” Harrington said.

Russell also welcomed the clarity, adding that taxpayers had been afraid that a foot fault might bring the whole tax due.

The proposed regs provide for the “eligible section 965(h) transferee exception” to escape acceleration. Events eligible for the exception include liquidations, sales, exchanges, or other dispositions of substantially all of the assets of a person, a corporation that was not a member of any consolidated group becoming a member, and a consolidated group ceasing to exist by reason of acquisition and immediately joining another consolidated group.

A transfer agreement must be entered into to be eligible for the exception. That agreement must include an agreement by the eligible section 965(h) transferee to assume the liability of the eligible section 965(h) transferor for any unpaid installment payments.

Calianno said the fleshing out of “any similar circumstance” regarding acceleration of payment to include exchanges or other dispositions is noteworthy.

Left Unsaid

Practitioners remain frustrated by the refusal of Treasury and the IRS to address broader concerns.

“Some of the most interesting aspects of the proposed regulations are the things that they either did not address or addressed in an intentionally limited manner,” Harrington said, citing to the proposed regs’ clarification that an individual making a section 962 election does take section 965(c) into account in the calculations while also noting that no other deduction is permitted. “Although the preamble notes that more fulsome amendments to the section 962 regulations are required, the wording in the proposed regulations does invite one to wonder whether the IRS and Treasury are signaling how they plan to come out on whether the section 250 deduction is permitted to an individual making a section 962 election.”

Russell said there are still unanswered questions on the reporting of section 965 amounts. There was a fear among CPAs about whether a Form 5471, “Information Return of U.S. Persons With Respect To Certain Foreign Corporations,” would meet the requirement that it be substantially complete to avoid penalties.

“You’ve got for the first time all these numbers that have never shown up on a [Form] 5471. There’s not even a line to show it on the form. How do I know what to put on there, or if I don’t put something on there are you going to consider it not substantially complete?” Russell asked. He acknowledged that it appears the guidance did not want to address administrative questions.

Both Calianno and Harrington also found it noteworthy that Treasury and the IRS declined to address further the repeal of section 958(b)(4) regarding downward attribution.

“[It] makes one wonder whether that is simply restraint by the drafters of the regulation or a hint that broader relief may not be in the cards,” Harrington said. “Since this is just the first of many regulations implementing TCJA, we’ll just have to see.”

Robert M. Russell, Esq., CPA, has accomplished a lifetime of success in little more than a decade of legislative practice, having solidified his presence as a congressional authority on international tax policy and other cross-border matters.


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