March 22, 2018 IRS reporting guidance on Section 965 transition tax has state tax implications On March 13, 2018, the Internal Revenue Service (IRS) issued guidance1 in the form of frequently asked questions (the 965 FAQs) for United States (US) shareholders to report the "transition tax" on the accumulated foreign earnings of their foreign subsidiaries on their 2017 US federal income tax returns. This action is prescribed by Internal Revenue Code (IRC) Section 965, which was enacted by Section 14103 of the Tax Cuts and Jobs Act (P.L. 115-97) (TCJA). The 965 FAQs will have implications for US state and local (collectively, state) personal, corporate and business tax reporting purposes, although such state implications are most significant for corporate taxpayers (i.e., C corporations). Accordingly, this Alert focuses on the state corporate income tax implications of the guidance provided in the 965 FAQs. Background IRC Section 965(a) generally requires US shareholders to recognize as subpart F income, for the last tax year beginning before January 1, 2018, the accumulated foreign earnings of controlled foreign corporations and other foreign corporations with a 10% US domestic corporate shareholder. IRC Section 965(c) also provides taxpayers with a deduction for such recognized amounts that results in an effective tax rate of 15.5% for the portion of earnings held in cash and other listed assets (essentially cash equivalents and certain other short-term assets) or 8% for the remaining amount of earnings. In addition, IRC Section 965(h) provides taxpayers the opportunity to elect to pay the transition tax liability in eight annual installments. Summary of 965 FAQs The form of the transition tax guidance is somewhat unusual. Rather than issuing a notice, revenue procedure or proposed regulations, the IRS instead developed a series of "questions and answers" referenced through a web link in a news release it issued announcing the 965 FAQs (the 965 News Release). The 965 FAQs generally instruct a taxpayer to report the transition tax on a separate "IRC 965 Transition Tax Statement" attached to its 2017 federal income tax return (the 965 Statement).2 The 965 FAQs list items that must be included in the 965 Statement, such as the amount included in the taxpayer's income under IRC Section 965(a), the amount of the taxpayer's total deduction under IRC Section 965(c), and the total net tax liability under IRC Section 965. They also provide a sample statement to make the election to pay the tax in installments over eight years. The 965 FAQs even contain a model "IRC 965 Transition Tax Statement" for further demonstrative guidance. Perhaps most important for state purposes is that the 965 FAQs make clear that all of these determinations and the components of the transition tax for corporate taxpayers will essentially be reported in the 965 Statement and thus "off the return" since the IRC Section 965 amounts will not be included in the calculation of taxable income on Page 1 of the IRS Form 1120.3 4 Accordingly, it appears that neither the IRC Section 965(a) income nor the IRC Section 965(c) deduction will be reported as part of federal taxable income before the net operating loss deduction and special deductions (Line 28) or in federal taxable income (Line 30) and instead will be reported on the separate 965 Statement as previously described. In addition, the 965 FAQs indicate that the resulting net tax liability under IRC Section 965 as calculated on the 965 Statement will be reported on specified lines of Schedule J (Tax Computation and Payment) of the IRS Form 1120. When paying 2017 federal income taxes, the 965 FAQs also instruct taxpayers to make two separate payments: one payment reflecting tax owed without regard to IRC Section 965, and a second, separate payment reflecting tax owed resulting from IRC Section 965 (the 965 Payment). Both payments must be paid by the due date of the applicable return (without extensions).5 The 965 Payment may be for the full net tax liability or for the first installment (for taxpayers making an election to pay the net tax liability in installments under IRC Section 965(h)). For more information on the US federal income tax treatment of the transition tax and the 965 FAQs, see Tax Alert 2018-0602. For more information on the state tax implications of the transition tax, see Tax Alert 2017-2171. State corporate income tax implications From a state corporate income tax perspective, the 965 FAQs raise yet another level of uncertainty for the preparation of 2017 state corporate income tax returns since, historically, the reporting of state tax calculations typically relied upon reference to specific lines of the IRS Form 1120, and such states' instructions were made either by administrative guidance or, in a few cases, directed by statute or regulations. That said, the 965 FAQs do nothing to change the federal statute. Specifically, the 965 FAQs provide guidance on reporting relevant IRC Section 965 amounts rather than providing guidance on the application of the federal statute. Thus, the mandatory inclusion in federal gross income of the accumulated foreign earnings of relevant foreign subsidiaries of corporations that are US shareholders remains directed by IRC Section 965(a), and the associated deduction continues to be directed by IRC Section 965(c). In considering state conformity, such statutory provisions generally will continue to control over whatever reporting instructions the IRS has provided. Accordingly, in most states (but not necessarily all), such IRC Section 965 amounts will continue to impact the statutory state tax base for which a state's subtraction modification, dividends received deduction, exclusion or other deduction mechanisms will apply (as applicable). The state reporting ambiguity, however, remains: How does this release affect the filing of state corporate income tax returns that are affected by IRC Section 965? The IRS guidance in the 965 FAQs is new, and very few states have begun to respond to it.6 Accordingly, taxpayers and their preparers alike await specific guidance from the states as to how they should report the transition tax amounts for state corporate income tax purposes. Perhaps some states might require taxpayers to attach to the return a reconciliation statement reflecting the addition of the IRC Section 965 amounts to the IRS Form 1120 Line 28 (or Line 30) amount before reporting the resulting adjusted federal taxable income amount as the starting point on the state return. Others might continue to tie the state starting point to the IRS Form 1120 Line 28 (or Line 30) but then mandate a state addition modification for the IRC Section 965 amounts (perhaps supported by a similar statement or even a new state form). We expect the state taxing authorities will continue to issue guidance as to whether the state will conform to IRC Section 965 itself, as well as quickly begin issuing their own reporting guidance in response to the 965 FAQs. We are continually following the many active state legislative sessions in which state lawmakers, often with the help of state taxing authorities, are considering conformity to the TCJA provisions including, notably, the transition tax. As such, we will continue to monitor activity in the various states and will provide updates on their responses as they become available. ———————————————
——————————————— 1 IRS News Release IR-2018-53, IRS provides additional details on section 965, transition tax; Deadlines approach for some 2017 filers (March 13, 2018) (available here (last accessed March 21, 2018)) (the 965 News Release). The 965 News Release contains a hyperlink to the "FAQ" document that contains the actual IRS guidance, Questions and Answers about Reporting Related to Section 965 on 2017 Tax Returns (available here (last accessed March 21, 2018)) (the 965 FAQs). 2 965 FAQs #3. 3 This reporting guidance for corporate taxpayers is unlike the guidance for individual taxpayers, which requires the net IRC Section 965 amount (i.e., IRC Section 965(a) income less IRC Section 965(c) deduction) to be reported on Line 21, Other Income, of the IRS Form 1040, in addition to being reported on the 965 Statement. 4 That, in turn, means the IRC Section 965(a) income will not be reported in the corporate taxpayer's federal gross income (Line 11, Total Income), nor will the IRC Section 965(c) deduction be reported in federal deductions (Line 27, Total Deductions) or special deductions (Line 29b, Special Deductions), on the taxpayer's 2017 federal income tax return. 5 965 FAQs #10. 6 The Illinois Department of Revenue (the Department), for example, recently provided taxpayers with reporting guidance in response to the 965 FAQs. In that guidance, the Department states that, "[d]ue to the separate nature of the [965 Statement], the income reported may not be included in federal taxable income; however, it must be included when determining Illinois base income. See the revised instructions associated with your specific return type for information on how to report IRC Section 965 net income. Taxpayers who have already filed a 2017 Illinois income tax return and did not include IRC Section 965 net income must amend their return to account for that income." 2017 Illinois Income Tax Guidance - Foreign Income Repatriation Transition Tax, IDOR Informational Bulletin FY 2018-23 (Mar. 2018) (available here (last accessed March 21, 2018)). | |||||||||||||||||||||||||
| |||||||||||||||||||||||||
