Domestic and Foreign Corporations: New Guidance Clarifies Earnings Computation Under Transition Tax

Taxpayers affected by the mandatory income inclusion rule under revised Internal Revenue Code Section 965 should be aware of new guidance from the IRS.  Section 965 imposes a transition tax as part of the shift to a territorial tax system.  Congress left it to the IRS and Treasury Department (Treasury) to work out many of the details in future regulations.  The IRS previously issued a partial description of the regulations Treasury intends to issue in Notice 2018-7, 2018-4 I.R.B. 1.  Notice 2018-13; 2018-6 I.R.B. 1, modifies and expands on the description contained in Notice 2018-7.

The Tax Cuts and Jobs Act of 2017 created a limited territorial tax system for corporations organized in the United States.  Previously, domestic corporations had the burden of tax imposed on their worldwide income and the benefit of deferral.  Beginning January 1, 2018, tax deferral for domestic corporations that own 10% or more of foreign corporations will effectively end.  Instead, these domestic corporations will receive a 100% participation exemption in the form of a dividends received deduction on their foreign source dividend income.  As part of the transition to these new rules, Congress determined that previously deferred offshore earnings and profits (E&P) must be included in income and taxed at a reduced rate under Section 965 (the mandatory income inclusion rule or transition tax).

In Notice 2018-7, the IRS provided a partial description of the regulations the Treasury intends to issue on the transition tax.  Among other things, it established a gain reduction rule applicable to distributions attributable to previously taxed income.  In principle, this rule prevents the double-taxation of earnings captured by the transition tax.

On January 19, 2017, the IRS issued Notice 2018-13, which clarifies that the gain reduction rule described in Notice 2018-7 applies to distributions received through a chain of ownership.  Most of Notice 2018-13 is dedicated to additional descriptions of the regulations the Treasury intends to issue in connection with the application of Section 965.

Notice 2018-13 provides new guidance in six areas: 

1.  It clarifies the interplay between a specified foreign corporation (SFC) and a deferred foreign income corporation (DFIC).  Simply put, DFIC trumps SFC.  A SFC that meets the definition of a DFIC will be treated as a DFIC and not also as a SFC.

2.  The notice recognizes the impracticality of asking taxpayers to determine post-1986 E&P on November 2, 2017 (one of two measurement dates, the other being December 31, 2017).  It states that the forthcoming regulations will provide an alternative method that taxpayers may elect to determine their post-1986 E&P.  The alternative method will measure the post-1986 E&P as the sum of E&P as of October 31, 2017 and what is effectively a two-day portion of the corporation’s annualized E&P.  For this purpose, the applicable portion of annualized E&P is twice the average daily earnings for the tax year as of the close of October 31, 2017.  The notice promises further guidance regarding the alternative method.

3.  The notice elucidates the treatment of deficits.  Forthcoming regulations will contain an ordering rule whereby taxpayers must allocate E&P deficits first among shareholders of the corporation’s common stock and in proportion to the value of the common stock.  Moreover, such regulations will also clarify that hovering deficits are considered in determining a SFC’s post-1986 E&P.

4.  The notice defines “accounts receivable.”  Forthcoming regulations will define accounts receivable as receivables described under section 1221(a)(4).  Similarly, they will also define accounts payable as payables from purchased property described under section 1221(a)(1) or (a)(8) or the receipt of services from vendors or suppliers.  In addition, for purposes of determining a SFC’s aggregate cash position, a loan that must be repaid on demand or within one year of demand of the lender will be treated as a short-term obligation, regardless of the terms of the instrument.

5.  The notice provides three currency translation rules.  One, taxpayers must measure E&P in the SFC’s functional currency.  Two, taxpayers must translate amounts from functional currency into US dollars using the spot rate on December 31, 2017.  Three, taxpayers must measure cash positions and fair market values in U.S. dollars.

6.  The notice provides some relief for taxpayers affected by the repeal of Section 958(b)(4).  Before its repeal, Section 958(b)(4) had prevented the downward attribution of stock from a foreign person to certain U.S. persons, such as U.S. corporations for subpart F purposes.  Thus, a domestic corporation could not constructively own stock in a foreign corporation that was directly held by the domestic corporation’s foreign shareholder.  The repeal of Section 958(b)(4) would allow certain U.S. entities to be attributed foreign stock held by their foreign owners.  In addition to subjecting these U.S. entities to tax under subpart F, the repeal potentially opens the floodgates to a torrent of additional Form 5471 filing obligations for certain domestic corporations.  Notice 2018-13 provides relief from the Form 5471 filing obligation for certain constructive owners of a controlled foreign corporation (CFC).  There are two requirements.  First, no U.S. shareholder can own, directly or through other foreign entities, stock in the CFC.  Second, the foreign corporation must be a CFC solely because the U.S. person is considered to own the stock through downward attribution from a foreign person.

Many U.S. and foreign multinationals will be impacted by the mandatory income inclusion under Section 965.  Taxpayers who have structures and transactions that rely on deferral of foreign earnings will be well advised to consider revisiting them.  We urge affected taxpayers to conduct E&P and tax pool studies as soon as possible if they are not already doing so.  As noted above, this notice provides significant relief from potential Form 5471 filing obligation for certain constructive owners.  The IRS promises additional guidance on the transition tax and other topics related to the Tax Cuts and Jobs Act of 2017.  We will continue to monitor future changes and provide updates to expand on key areas that could impact you.

For more information, please contact James Wall, Principal, International Tax Practice, at 646-254-7460 or James.Wall@CohnReznick.com.

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