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August 5, 2018
2018-1571

US Treasury Department releases proposed Section 965 regulations

On August 1, 2018, the Treasury Department issued proposed regulations under and related to Internal Revenue Code (Code) Section 965 (Proposed Regulations).

The Proposed Regulations include, with certain modifications, the provisions announced in three prior IRS Notices (Section 965 Notices), one revenue procedure, various "frequently-asked questions" released by the IRS concerning the payment and reporting of a taxpayer's Section 965 inclusion and related tax liability, and IRS Publication 5292. The Proposed Regulations not only implement the rules described in the Section 965 Notices, but also provide additional rules related to:

  • Determinations of foreign tax credits associated with Section 965 inclusions and distributions of previously taxed earnings and profits (E&P) created by Section 965
  • Adjustments to E&P and stock basis
  • Affiliated groups, including affiliated groups that file consolidated returns
  • Transactions, accounting methods changes and entity-classification elections to be disregarded for purposes of Section 965
  • Subpart F income otherwise earned by foreign corporations during the inclusion year and
  • Expense allocation and apportionment

These rules and the other provisions in the Proposed Regulations are discussed below.

Section 965: Background

Section 965(a) generally provides that the subpart F income of a specified foreign corporation (SFC) (i.e., a controlled foreign corporation (CFC) and any other foreign corporation that has a 10% corporate US shareholder) in its tax year that begins before January 1, 2018 (inclusion year) is increased by the greater of its accumulated post-1986 deferred foreign income determined on November 2, 2017, and December 31, 2017 (Section 965(a) earnings amount and inclusion dates, respectively). A SFC that has accumulated post-1986 deferred foreign income is referred to as a deferred foreign income corporation or a DFIC.

A SFC's accumulated post-1986 deferred foreign income equals its post-1986 E&P on a measurement date reduced by any E&P attributable to income that is effectively connected with the conduct of a trade or business in the United States (ECI) and subject to tax under the Code or that if distributed would be excluded from the gross income of a United States shareholder under the Section 959 exclusion for previously taxed E&P (PTI). Generally the post-1986 E&P of a SFC equals E&P accumulated in years ending after December 31, 1986, but only during periods in which the foreign corporation was a SFC, and by diminution for dividends made during the inclusion year to other SFCs.

Reduction in inclusion for the foreign E&P deficits. Under Section 965(b), if a US shareholder owns at least one DFIC and at least one E&P deficit foreign corporation, then the amount of the Section 965(a) earnings that would otherwise be included in the income of the US shareholder under Section 951(a) is reduced by the amount of the US shareholder's aggregate foreign E&P deficit (such reduced amount, the Section 965(a) inclusion amount). An E&P deficit foreign corporation is, with respect to a US shareholder, a SFC with respect to which, as of November 2, 2017: (1) the SFC had a deficit in post-1986 E&P; (2) the corporation was a SFC; and (3) the shareholder was a US shareholder of the corporation. The deficit in post-1986 E&P as of November 2, 2017, of an E&P deficit foreign corporation is a specified E&P deficit. The US shareholder's aggregate foreign E&P deficit is the total of its pro rata share of specified E&P deficits of its E&P deficit foreign corporations. The last tax year of an E&P deficit foreign corporation that begins before January 1, 2018, is also referred to as the inclusion year discussed below.

Section 965(c) deduction. Under Section 965(c), a US shareholder is entitled to a deduction that is intended to reduce the applicable tax rate on the Section 965(a) inclusion amount to 15.5% on a portion of the inclusion amount and 8% on the remainder. More specifically, the 15.5% tax rate applies to the portion of the Section 965(a) inclusion amount equal to a US shareholder's aggregate foreign cash position, and the 8% tax rate applies to the remaining amount. Aggregate foreign cash position means the greater of the US shareholder's aggregate pro rata share of the cash position of its SFCs determined on the last day of the SFCs' inclusion year, or the average of the US shareholder's pro rata share of the cash position of its SFCs determined in the two years ending immediately before November 2, 2017 (each a cash measurement date). For the purposes of this calculation, a SFC's cash position is comprised of its cash; net accounts receivable; and the fair market value of personal property that is of a type that is actively traded and for which there is an established financial market, commercial paper, certificates of deposit, certain government securities, foreign currency, obligations with a term less than a year, and any asset determined by the Secretary to be economically equivalent to these assets.

Liability payable over 8 years. In general, taxpayers may elect to pay the net tax liability resulting from the Section 965(a) inclusion amount in installments. The net tax liability is determined based on the taxpayer's net income tax for the tax year in which a Section 965(a) inclusion amount is recognized over the taxpayer's net tax liability for that tax year, but determined without regard to Section 965 and any income or deduction properly attributable to dividends received by that US shareholder from a DFIC.

Summary of prior Section 965 Notices

As described above, Treasury and the IRS issued three Notices, an FAQ and a Revenue Procedure pursuant to their authority under Section 965(o). With respect to the Notices, first, Notice 2018-07 (issued on December 29, 2017) describes rules related to: (1) the measurement and allocation of the aggregate foreign cash position; (2) the determination of accumulated post-1986 deferred foreign income (including an ordering rule); (3) a gain reduction rule related to current-year distributions in excess of basis; (4) the treatment of a consolidated group as a single US shareholder for purposes of Section 965; and (5) the determination of foreign currency gain or loss under Section 986(c) on the distribution of PTI resulting from a Section 965 inclusion amount.

Second, Notice 2018-13 (issued on January 19, 2018) describes rules related to: (1) the definition of an E&P deficit foreign corporation; (2) an alternative method for determining the post-1986 E&P of a SFC on November 2, 2017; (3) the allocation and definition of a specified E&P deficit; (4) the meaning of accounts receivable and accounts payable for purposes of determining the aggregate foreign cash position of a SFC; (5) the treatment of a demand loan for purposes of the cash position; (6) the translation of E&P maintained in a foreign currency to the US dollar; and (7) the modification of the gain reduction rule first announced in Notice 2018-07.

Third, Notice 2018-26 (issued on April 2, 2018) describes anti-avoidance rules in respect of transactions, accounting-method changes, and elections that were filed on or after November 2, 2017, along with other guidance on elections reporting procedures. The Notice also provides relief from certain estimated tax payment requirements and penalties for the transition tax and certain TCJA changes to stock attribution rules.

For more information on the Transition Tax, see Tax Alert 2017-2166. Prior guidance by Treasury and the IRS include Notice 2018-07 (Tax Alert 2017-2232), Notice 2018-13, Revenue Procedure 2018-17 (Tax Alert 2018-0366), Notice 2018-26, as well as frequently asked questions (Tax Alert 2018-0602).

Detailed discussion

The following discussion describes the Proposed Regulations with particular focus on changes made to the statutory provisions and prior guidance. This discussion follows the organization of the Proposed Regulations, which is divided into similar sections.

General, operative rule

The Proposed Regulations provide that the subpart F income of a DFIC is increased by the amount of its Section 965(a) earnings amount and, accordingly, a US shareholder of the DFIC generally includes in its gross income its pro rata share of the Section 965(a) earnings amount (subject to the reduction below). Consistent with Notice 2018-13, the Proposed Regulations provide that, regardless of a SFC's tax year or the applicable measurement date, the US shareholder's pro rata shares of the Section 965(a) earnings amount and specified E&P deficits is translated from the DFIC's or E&P deficit foreign corporation's (as applicable) functional currency into US dollars at the spot rate on December 31, 2017. Further, the amount of the US shareholder's inclusion is neither subject to the rules or limitations in Section 952 nor limited by the accumulated E&P of the DFIC.

The Proposed Regulations further provide that, for purposes of determining a US shareholder's Section 965 inclusion amount with respect to a DFIC, the shareholder's Section 965(a) earnings amount is reduced by the DFIC's allocable share of the US shareholder's aggregate foreign E&P deficit under Section 965(b). Consistent with Notice 2018-07, all US shareholders that are members of the same consolidated group are treated as a single US shareholder for purposes of applying Section 965(b), for purposes of determining the aggregate foreign E&P deficit allocated to a DFIC and for certain other purposes. However, as described in more detail below, the Proposed Regulations provide that, in general, the members of a consolidated group are not otherwise treated as a single US shareholder for purposes of Section 965, except for certain enumerated purposes.

Key definitional rules

Status of a SFC as a DFIC or E&P deficit corporation. Consistent with Notice 2018-13, the Proposed Regulations provide that a SFC is a DFIC if it has a positive amount of post-1986 E&P on one of the measurement dates, even if the SFC has a post-1986 E&P deficit on November 2, 2017. However, in some cases a SFC may be neither a DFIC nor an E&P deficit foreign corporation if for example it is not an E&P deficit foreign corporation due to its having PTI.

Post-1986 E&P includes PTI and certain dividend amounts. The Proposed Regulations confirm that a SFC's post-1986 E&P includes PTI. As a result, for example, a SFC with $100x PTI and a $80x deficit in non-PTI post-1986 E&P as November 2, 2017, is not an E&P deficit company even though it does not have accumulated post-1986 deferred foreign income (because the PTI is excluded for that purpose). Treasury explains in the preamble to the Proposed Regulations that PTI is a type of E&P, and there is no express exclusion of PTI for determining post-1986 E&P under Section 965(d)(3) in contrast to an exclusion for PTI in the definition of accumulated post-1986 deferred foreign income in Section 965(d)(2)(B).

Post-1986 E&P of a SFC is generally reduced by the amount of dividends distributed to another SFC in the inclusion year under the statute. However, the Proposed Regulations provide that this reduction is limited to the increase in post-1986 E&P of the distributee SFC by reason of dividend. For example, a distribution of property with adjusted basis of $80x but fair market value of $40x only reduces the E&P of the distributing SFC by $40x.

Under the Proposed Regulations, consistent with Notice 2018-26, if foreign income taxes would accrue to the SFC after November 2, 2017, but on a date that is both within the SFC's tax year that includes November 2, 2017, and on or before December 31, 2017, the SFC's post-1986 E&P determined as of November 2, 2017, is reduced for that portion of foreign income taxes of the SFC that is attributable to the portion of income that accrued as of November 2, 2017. Like Notice 2018-26, no relief in this regard is provided for fiscal year SFCs or other SFCs with respect to which foreign income taxes accrue after December 31, 2017, or in tax years that do not include November 2, 2017.

Exclusion of PTI from accumulated post-1986 deferred foreign income. Although the statute generally excludes PTI from a SFC's accumulated post-1986 deferred foreign income (the PTI exclusion), the Proposed Regulations limit the exclusion to the amount of actual subpart F income earned by the SFC as of a measurement date. For example, if a SFC's sole subpart F income is earned during its inclusion year but entirely after November 2, 2017, then no portion of its post-1986 E&P as of November 2, 2017, would be considered PTI. This rule, therefore, adjusts the statutory provision to account for the fact that PTI created by current year subpart F income inclusion can be distributed earlier in the tax year because of the priority rules under Section 959.

This new rule appears to require a SFC to reflect a "hard" closing of its books on November 2, 2017, and December 31, 2017, to properly measure its subpart F income, although it's possible Treasury may provide a safe-harbor for this purpose, similar to the determination of post-1986 E&P as of November 2, 2017

Conversely, consistent with Notice 2018-07, the Proposed Regulations increase the amount of the PTI exclusion to the extent that a SFC that is a CFC has non-US shareholders on a measurement date and such SFC would have had an additional PTI exclusion amount had those non-US shareholders instead been US persons. This amount is to be determined in a manner consistent with Revenue Ruling 82-16, 1982-1 C.B. 106.

Controlled domestic partnership rule. The Proposed Regulations provide that a controlled domestic partnership (CDP) is treated as foreign for purposes of Section 965. This special rule applies, (1) if the CDP is otherwise a US shareholder of a SFC and (2) if the CDP (and any other CDPs in the chain of ownership of the SFC) is foreign, the SFC would continue to be a SFC, and at least one US shareholder of the SFC would be treated as a US shareholder of the SFC and would be treated as owning (under Section 958(a)) the stock owned (under Section 958(a)) by the CDP through another foreign corporation that is a direct or indirect partner in the CDP.

A CDP is a US partnership controlled by a US shareholder and related persons. Control for these purposes is determined based on all the facts and circumstances, except a partnership is deemed to be controlled by a US shareholder and related persons (within the meaning of Section 267(b) or Section 707(b)(1)) if those persons in the aggregate own (directly or indirectly through one or more partnerships) more than 50% of the interests in the partnership by capital or profits.

The preamble to the Proposed Regulations references, and the rules provided in the Proposed Regulations are in many ways similar to, Notice 2010-41, 2010-22 I.R.B. 715.

Prop. Reg. Section 1.965-2: Adjustments to E&P and basis

Consistent with Notice 2018-07, the Proposed Regulations provide the following ordering rules to coordinate the application of Sections 951, 956, 959, and 965 to a SFC's inclusion.

  • First, the actual subpart F income of a SFC is determined and the SFC's E&P is adjusted to the extent a US shareholder of the SFC includes such amount in income under Section 951(a)(1).
  • Second, the treatment of distributions made by the SFC before January 1, 2018 to another SFC, is determined under Section 959.
  • Third, the SFC's post-1986 E&P (including a deficit), accumulated post-1986 deferred foreign income, and Section 965(a) inclusion amount with respect to a US shareholder is determined.
  • Fourth, the treatment of all distributions (other than those covered in the second step) made by the SFC are determined under Section 959.
  • Fifth, amounts under Section 956 are determined with respect to a US shareholder.

A SFC's E&P is adjusted following each step above. Consistent with Sections 959 and 965(b)(4), as part of the third step, the Proposed Regulations require adjustments to the E&P (including a deficit) of a DFIC or E&P deficit foreign corporation in part, to reflect the allocation of aggregate foreign E&P Deficit to a DFIC under Section 965(b) that reduces the Section 965(a) inclusion amount. These adjustments to E&P as well as certain basis adjustments are discussed below.

Section 965(b) PTI. Pursuant to Section 965(b)(4)(A), the amount by which a US shareholder's Section 965(a) inclusion from a DFIC is reduced due to the allocation of an aggregate foreign E&P deficit is, for the purposes of Section 959, treated as an amount included in the gross income of its US shareholder(s) under Section 951(a) and, thus, is treated as PTI for certain purposes (Section 965(b) PTI). Similarly, the Section 959(c)(3) E&P of a DFIC (or E&P that would be described in Section 959(c)(3) if not for the application Section 965) is reduced by the amount equal to the Section 965(a) PTI.

The Proposed Regulations explicitly provide that the decrease in Section 959(c)(3) E&P resulting from both Section 965(a) PTI and Section 965(b) PTI can result in a deficit in that category of E&P.

E&P increases for an E&P deficit foreign corporation. Section 965(b)(4)(B), in turn, increases a US shareholder's pro rata share of the E&P of a E&P deficit foreign corporation in the inclusion year by the amount of the specified E&P deficit taken into account by the US shareholder under Section 965(b). The Proposed Regulations provide that this increase is not treated as current-year E&P under Section 316(a)(2) for purposes of Section 316. Further, for purposes of Section 902 (but not for other purposes), this increase occurs as of the first day of the foreign corporation's first tax year following its inclusion year.

If the specified E&P deficit of an E&P deficit foreign corporation includes a qualified deficit, the Proposed Regulations also provide that the US shareholder's pro rata share of the E&P of such E&P deficit foreign corporation for purposes of adjusting the qualified deficit under Section 952, is increased by the specified E&P deficit taken into account under Section 965(b), and such increase is attributable to the same activity that gave rise to the deficit that was taken into account.

Basis adjustments. The Proposed Regulations provide for basis adjustments to be made to stock held by a US shareholder in a SFC or applicable property with respect to the SFC. These adjustments are referred to in Prop. Reg. Section 1.965-3(h) as "specified basis adjustments." The specified basis adjustments: (1) occur as of the close of a SFC's inclusion year; (2) are a single net basis adjustment in the case of multiple specified basis adjustments; and (3) are made with respect to each share. The specified basis adjustments are made solely with respect to stock or other applicable property owned directly by the US shareholder. Applicable property is property owned directly by the US shareholder, including through one or more foreign pass-through entities, through which a US shareholder is considered under Section 958(a)(2) as owning stock of a SFC. Property for this purpose includes stock in a foreign corporation, an interest in a foreign partnership, or a beneficial interest in a foreign estate or trust. The excess of any net reduction in basis over the US shareholder basis in such stock or applicable property is treated as gain from the sale or exchange of property.

Consistent with Section 961(a), discussed below, the Proposed Regulations provide a basis increase to the stock of a SFC or applicable property with respect to a DFIC by the amount of the Section 965(a) inclusion amount with respect to the DFIC. The Proposed Regulations provide for elective basis adjustments in respect of Section 965(b) PTI and also provide for basis adjustments to account for the consequences of the gain reduction rule.

Elective basis adjustment by reason of Section 965(b). Under Section 961(a), the basis of a US shareholder's stock in a CFC is increased by the amount included in the US shareholders gross income under Section 951(a) (e.g., a subpart F inclusion) with respect to such stock. Pursuant to Section 961(b)(1), the adjusted basis of the stock held by the US shareholder of a CFC is reduced by the amount of a distribution of PTI. Under Section 961(b)(2), the US shareholder is required to recognize gain to the extent the amount of PTI distributed exceeds the US shareholder's adjusted basis in the stock of the foreign corporation.

In general, the Proposed Regulations provide that no adjustment is made to the basis of stock (or other property) with respect to a DFIC to account for any Section 965(b) PTI. As a result, a distribution of Section 965(b) PTI by the DFIC may in certain circumstances result in gain recognition under Section 961(b)(2).

The Proposed Regulations permit a US shareholder to elect to make the following basis adjustments (basis adjustment election):

  • The US shareholder's basis in the stock of each DFIC (or applicable property with respect to the DFIC) is increased by the US dollar amount of the Section 965(b) PTI with respect to that US shareholder.
  • The US shareholder's basis in the stock of an E&P deficit foreign corporation (or applicable property with respect to such foreign corporation) is reduced by the US shareholder's pro rata share of the foreign corporation's specified E&P taken into account by the US shareholder under Section 965(b). To the extent that the amount of this reduction exceeds the US shareholder's adjusted basis in the stock or applicable property, the US shareholder is required to recognize gain in the amount of such excess.

A US shareholder and all related persons must make the basis adjustment election, and the election is applied to all DFICs and E&P deficit foreign corporations. Further, the basis adjustment election must be made with the US shareholder's first return which includes a Section 965(a) inclusion. For example, a US shareholder with a calendar tax year that owns a DFIC with a calendar tax year must make the basis adjustment election with its 2017 tax return.

Gain reduction rule and correlative basis adjustments. Consistent with Notice 2018-07 and Notice 2018-13, the Proposed Regulations provide that if a US shareholder receives distributions from a DFIC (including through a chain of ownership described in Section 958(a)) during the inclusion year (relevant distributions) attributable to Section 965(a) PTI, the amount of gain recognized by the US shareholder with respect to the stock of the DFIC under Section 961(b)(2) will be reduced (but not below zero) by the amount of the Section 965(a) inclusion amount (gain-reduction rule). The Proposed Regulations also extend the gain-reduction rule to relevant distributions attributable to Section 965(b) PTI if the US shareholder has made a basis adjustment election.

If a US shareholder does not recognize gain because of the gain-reduction rule then the basis in the DFIC stock or other applicable property is reduced by the amount of gain that would have otherwise been recognized by the US shareholder.

Prop. Reg. Section 1.965-3: Section 965(c) deductions

Consistent with Notice 2018-07, the Proposed Regulations provide that, for purposes of determining the aggregate foreign cash position of a US shareholder, accounts receivable, accounts payable, short-term obligations, and derivative financial instruments between related SFCs are in some circumstances disregarded on the corresponding cash measurement dates of the SFCs to the extent of the smallest ownership percentage of stock of the SFCs owned by the US shareholder on the corresponding measurement dates.

Consistent with the statute, the Proposed Regulations also provide, in the case of other net accounts receivable, actively traded property and short-term obligations, a US shareholder may exclude such amounts to the extent such amounts are attributable to amounts taken into account in determining the US shareholder's pro rata share of the cash position of another SFC on the applicable cash measurement date — that is, to the extent that they would give rise to double counting of cash and equivalent assets. However, consistent with Notice 2018-26 and the verification requirements imposed by Section 965(c)(3)(D), a US shareholder may only disregard these amounts if the shareholder attaches an information statement that includes the necessary information (e.g., description of the assets taken into account with respect to both SFCs) with its timely filed return (taking into account extensions). No late filing relief is available for the filing of the information statement.

Also consistent with Notice 2018-07, rules in Prop. Reg. Section 1.965-3(c) determine the Section 965(c) deduction recognized by a Shareholder who has a Section 965(a) inclusion amount recognized in income in more than one period. The aggregate foreign cash position taken into account in the first year with a Section 965(a) inclusion is equal to the lesser of the US shareholder's aggregate foreign cash position or the aggregate Section 965(a) inclusion amount for the year. The amount of the US shareholder's aggregate foreign cash position in any succeeding year with a Section 965(a) inclusion is the lesser of the excess of its aggregate foreign cash position over the amount of its aggregate foreign cash position taken into account in the preceding year, or the aggregate Section 965(a) inclusion for that year.

Consistent with Notice 2018-07, the Proposed Regulations allow a US shareholder to estimate the aggregate foreign cash position by allowing the US shareholder to assume that its pro rata share of the cash position of any SFC whose last year begins before January 1, 2018, and ends after the date the US shareholder's tax return is timely filed (taking into account extensions) is zero. Interest and penalties are not imposed on a US shareholder that makes appropriate adjustments through an amended return to account for the updated aggregate foreign cash position, as long as the amended return is filed by the extended due date for the return for the year after the US shareholder inclusion year.

Anti-avoidance rules: Certain transactions, accounting methods changes and entity-classification elections disregarded for purposes of Section 965

The Proposed Regulations would disregard a large number of transactions that occur after November 2, 2017. First, consistent with rules set out in Notice 2018-26, the Proposed Regulations provide anti-avoidance rules that disregard transactions undertaken with a principal purpose of changing the amount of a "Section 965 element" (replacing the term "Section 965 liability" as used in Notice 2018-26) of a US shareholder (anti-avoidance rule). In a change from the Section 965(a) Notices, however, the Proposed Regulations provide only a narrow rule that would disregard transactions occurring between the measurement dates to address double-counting or double non-counting of post-1986 E&P.

Like Notice 2018-26, the Proposed Regulations also disregard certain accounting method changes (including a change from an impermissible method of accounting to a permissible method of accounting) and entity-classification elections.

Importantly, the Proposed Regulations disregard the consequences of these transactions, accounting-method changes and entity-classification elections only for purposes of Section 965. Neither Notice 2018-26 nor the Proposed Regulations coordinate the effect of disregarding these transactions, changes and elections for Section 965 purposes with the fact that they are not disregarded for other purposes. For example, the Proposed Regulations do not coordinate the consequences of transactions that would have been disregarded to the extent that an entity-classification election was effective, but that would not have been disregarded to the extent that it was not.

Transactions undertaken with a principal purpose of changing the amount of a Section 965 element. The Proposed Regulations generally provide that a transaction will be disregarded for purposes of determining the amounts of all Section 965 elements of a US shareholder if each of the following conditions is satisfied: (1) such transaction occurs, in whole or in part, on or after November 2, 2017 (the specified date); (2) such transaction is undertaken with a principal purpose of changing the amount of a Section 965 element of such US shareholder; and (3) such transaction would, without regard to this rule, change the amount of a Section 965 element of such US shareholder.

A change to the amount of a Section 965 element means, with respect to a US shareholder, any of the following amounts: (1) a reduction to the US shareholder's Section 965(a) inclusion amount with respect to a SFC; (2) a reduction to the aggregate foreign cash position of the US shareholder; and (3) an increase in the amount of foreign income taxes of a SFC deemed paid by the US shareholder under Section 960 as a result of a Section 965(a) inclusion.

Consistent with Notice 2018-26, cash reduction transactions, E&P reduction transactions and pro rata share transactions are generally presumed to be undertaken with a principal purpose of changing the amount of a Section 965 element of a US shareholder. The presumption may be rebutted only if facts and circumstances clearly establish that the transaction was not undertaken with a principal purpose of changing the amount of a Section 965 element of a US shareholder. A statement is required to be filed to rebut the presumption. Further, for cash reduction and E&P reduction transactions, the presumption does not apply to transactions that occur in the ordinary course of business. Similar to Notice 2018-26, the Proposed Regulations further provide that certain transactions are treated as per se undertaken with (or without) the principal purpose of changing the amount of a Section 965 element of a US shareholder.

Cash reduction transaction. A "cash reduction transaction" is: (1) a transfer of cash, accounts receivable, or cash equivalent assets (i.e., cash position assets) by a SFC to a US shareholder of the SFC or a person related to a US shareholder of such SFC, or (2) an assumption by a SFC of an accounts payable of a US shareholder of such SFC or a person related to a US shareholder of such SFC, if such transfer or assumption would, without regard to the anti-avoidance rule, reduce the aggregate foreign cash position of such US shareholder.

However, a distribution of a cash, accounts receivable, or cash equivalent assets by a SFC to a US shareholder of such SFC will be treated per se as not being undertaken with a principal purpose of changing the amount of a Section 965 element of such US shareholder if the distribution is not a specified distribution. A "specified distribution" is treated per se as undertaken with a principal purpose of changing the amount of a Section 965 element, and means a distribution by a SFC to a US shareholder if: (1) at the time of the distribution, there was a plan or intention for the distributee to transfer, directly or indirectly, cash, accounts receivable, or cash equivalent assets to any SFC of such US shareholder, or (2) the distribution is a non pro rata distribution to a foreign person that is related to such US shareholder.

E&P reduction transaction. An E&P reduction transaction means a transaction between a SFC and: (1) a US shareholder of such SFC, (2) another SFC of a US shareholder of such SFC, or (3) any person related to a US shareholder of such SFC, if such transaction would, without regard to the anti-avoidance rule, reduce the accumulated post-1986 deferred foreign income or the post-1986 undistributed earnings (as defined in former Section 902(c)(1)) of such SFC or another SFC of any US shareholder of such SFC.

In addition, a specified transaction will be treated per se as being undertaken with a principal purpose of changing the amount of a Section 965 element of a US shareholder for purposes of the anti-avoidance rule. Specified transaction means an E&P reduction transaction that involves one or more of the following: (1) a complete liquidation of a SFC to which Section 331 applies; (2) a sale or other disposition of stock by a SFC; or (3) a distribution by a SFC that reduces the E&P of such SFC pursuant to Section 312(a)(3).

Pro rata share transaction. A pro rata share transaction means a pro rata share reduction transaction or an E&P deficit transaction. A pro rata share reduction transaction means a transfer of the stock of a SFC by either a US shareholder of the SFC or a person related to a US shareholder of the SFC (including by the SFC itself) to a person related to the US shareholder if the transfer would, without regard to the anti-avoidance rule, reduce: (1) the US shareholder's pro rata share of the Section 965(a) earnings amount of the SFC; (2) the US shareholder's pro rata share of the cash position of the SFC; or (3) both. An E&P deficit transaction means a transfer to either a US shareholder or a person related to the US shareholder of the stock of an E&P deficit foreign corporation by a person related to the US shareholder (including by the E&P deficit foreign corporation itself) if the transfer would, without regard to the anti-avoidance rule, increase the US shareholder's pro rata share of the specified E&P deficit of the E&P deficit foreign corporation.

In addition, an internal group transaction will be treated per se as being undertaken with a principal purpose of changing the amount of a Section 965 element of a US shareholder for purposes of the anti-avoidance rule. Internal group transaction means a pro rata share transaction if, immediately before or after the transfer, the transferor of the stock of the SFC and the transferee of such stock are members of an affiliated group in which the US shareholder is a member.

Disregard of certain changes in method of accounting and entity classification elections. The Proposed Regulations provide that any change in method of accounting made on or after November 2, 2017, for a tax year of a SFC that ends in 2017 or 2018 will be disregarded for purposes of determining the amounts of all Section 965 elements of a US shareholder if such change in method of accounting would otherwise change the amount of any Section 965 element of such US shareholder, even if such a change is from an impermissible method to a permissible one. However, these regulations will not apply to a change in method of accounting for which the original and/or duplicate copy of any Form 3115, Application for Change in Accounting Method, requesting the change was filed before November 2, 2017.

The Proposed Regulations further provide that any entity classification election under Treas. Reg. Section 301.7701-3 that is filed on or after the specified date will be disregarded for purposes of determining the amounts of all Section 965 elements of such US shareholder, if such entity classification election would otherwise change the amount of any Section 965 element of the US shareholder.

The Proposed Regulations would disregard an accounting method change or entity classification election regardless of whether it is made with a principal purpose of changing the amount of Section 965 element of a US shareholder.

Disregard of certain transactions occurring between E&P measurement dates. The Proposed Regulations also provide a narrow rule that would disregard certain other transactions that occur between measurement dates to avoid double-counting or double non-counting of post-1986 E&P. Specifically, this rule would disregard a specified payment made by a SFC (payor SFC) to another SFC (payee SFC) for purposes of determining the post-1986 E&P of each of the payor SFC and the payee SFC as of the E&P measurement date on December 31, 2017. A specified payment means any amount paid or accrued by the payor SFC, including a distribution by the payor SFC with respect to its stock, if each of the following conditions is satisfied: (1) immediately before or immediately after the payment or accrual of the amount, the payor SFC and the payee SFC are related within the meaning of Section 954(d)(3); (2) the payor SFC and the payee SFC do not have the same tentative E&P measurement date; (3) the payment or accrual of the amount occurs after November 2, 2017, and on or before December 31, 2017; and (4) the payment or accrual of the amount would otherwise reduce the post-1986 E&P of the payor SFC as of the E&P measurement date on December 31, 2017. The tentative E&P measurement date means: (1) with respect to a SFC that would otherwise be an E&P deficit foreign corporation, the E&P measurement date as of November 2, 2017; and (2) with respect to a SFC not described in (1), the E&P measurement date of the SFC that otherwise would result in the greater amount of accumulated post-1986 deferred foreign income.

Prop. Reg. Sections 1.965-5 and -6: Foreign tax credit guidance

Section 965(g)(1) and (3), respectively, disallow a credit under Section 901 and deduction for the applicable percentage of any foreign income "taxes paid or accrued (or treated as paid or accrued)" with respect to any amount for which a Section 965(c) deduction is allowed. The applicable percentage is the sum of two percentages: (1) the US shareholder's aggregate Section 965(a) inclusion amount equal to its aggregate for cash position (allocated to that period) over the total Section 965(a) inclusion amount times 77.1%, plus (2) the US shareholder's aggregate Section 965(a) inclusion amount in excess of its aggregate for cash position (allocated to that period) over the total Section 965(a) inclusion amount times 55.7%. The Proposed Regulations clarify that the applicable percentage is separately determined by a US shareholder for each inclusion year. For example, a US shareholder may have DFICs with different inclusion years, and a different Section 965(c) deduction amount between those years.

The Proposed Regulations define taxes paid or accrued as foreign taxes directly paid or accrued by a taxpayer under Section 901, and define taxes treated as paid or accrued to mean foreign taxes deemed paid by the taxpayer under Section 960, foreign taxes allocated to its owner under Treas. Reg. Section 1.901-2(f)(4), and a distributive share of foreign taxes paid by a partnership. Accordingly, under the Proposed Regulations, no deduction or credit under Section 901 is allowed for the applicable percentage of any foreign taxes paid or accrued by a US shareholder with respect to any amount for which a Section 965(c) deduction is allowed. Likewise, no deduction or credit under Section 901 is allowed for the applicable percentage of any foreign taxes paid or accrued by a US shareholder attributable to a distribution of Section 965(a) PTI and Section 965(b) PTI.

Importantly, the Proposed Regulations explicitly provide that no deduction or credit is allowed for the applicable percentage of any withholding taxes imposed on a US shareholder by the country of residence of the distributing foreign corporation with respect to a distribution of Section 965(a) PTI and Section 965(b) PTI.

Similarly, under Prop. Reg. Section 1.965-5(c)(1), no credit under Section 901 is allowed for the applicable percentage of any foreign taxes treated as paid or accrued under Section 960 with respect to any amount for which a Section 965(c) deduction is allowed. As mentioned, such foreign taxes treated as paid or accrued that are subject to this limitation include, in part, foreign taxes paid under Section 960(a)(1) with respect to a Section 965(a) inclusion and foreign taxes deemed paid under Section 960(a)(3) with respect to distributions of Section 965(a) PTI and Section 965(b) PTI.

Foreign taxes deemed paid under Section 960(a)(3). The Proposed Regulations provide that foreign taxes deemed paid under Section 960(a)(3) with respect to a distribution of Section 965(a) PTI or Section 965(b) PTI include only the foreign taxes paid or accrued by an upper-tier foreign corporation with respect to a distribution of such PTI from a lower-tier foreign corporation. Accordingly, no credit would be allowed for foreign taxes under the Proposed Regulations that would have been deemed paid under Section 960(a)(3) with respect to the portion of a Section 965(a) earnings amount reduced under Section 965(b). In the preamble to the Proposed Regulations, Treasury stated that because Section 965(b) PTI is treated as having been included in a US shareholder's income under Section 951(a), the foreign taxes that would have been deemed paid with respect to the Section 965(b) PTI under Section 960(a)(1), had those amounts actually been included in the US shareholders income, are treated as having been deemed paid, with the result that no credit is allowed under Section 960(a)(3) or any other provision of the Code for such taxes.

The Proposed Regulations address the distribution of Section 965(a) PTI and Section 965(b) PTI only for years before the effective date of Section 960(b) (as enacted by the TCJA (new Section 960(b)). While the application of 965 and new Section 960(b) is reserved in the Proposed Regulations, the preamble indicates that Treasury and IRS intend to issue future regulations that provide similar rules in connection with new Section 960(b).

Computation of foreign income taxes deemed paid. The Proposed Regulations provide computational rules for foreign income taxes deemed paid under Sections 902 and 960. Generally, the deemed paid credit provided under Sections 902 and 960 apply in the same manner to a Section 965(a) inclusion amount as for non-Section 965 subpart F income inclusions. However, the Proposed Regulations provide that in no instance can the Section 902 fraction be greater than one. For this purpose the Section 902 fraction is the fraction of the dividend or inclusion under Section 951(a), including a Section 965 inclusion with respect to the foreign corporation (the numerator), divided by the foreign corporation's post-1986 undistributed earnings as defined by Section 902(c)(1) (the denominator). Without this rule, a 902 fraction greater than zero may occur when the Section 965 earnings amount with respect to a foreign corporation is greater than the corporation's post-1986 undistributed earnings as of the close of the corporation's year. When the denominator of the Section 902 fraction is positive, but less than the numerator, the Section 902 fraction is one. When the denominator of the section 902 is zero (or less than zero), the Section 902 fraction is zero and no foreign taxes are deemed paid.

Further, as noted above, the Proposed Regulations provide that, for the purposes of Section 902(c)(1) and determining the amount of foreign income taxes deemed paid by a US shareholder, the post-1986 undistributed earnings of the E&P deficit foreign corporation are increased as of the first year after the corporation's inclusion year.

Treatment of certain SFCs as CFCs is not applicable for Section 902 purposes. A SFC that is a foreign corporation with a 10% domestic corporate shareholder that is not otherwise a CFC (a 10/50 SFC), is treated as a CFC under Section 965(e)(2) for purposes of Sections 951 and 961. The Proposed Regulations and preamble provide that a 10/50 SFC is not treated as a CFC for purposes of Section 902 and, accordingly, no deemed paid credit under Sections 902 or 960 is available to a US shareholder of a 10/50 SFC that is below the third-tier in the chain of ownership. Note, however, a foreign corporation that otherwise would only be considered a 10/50 company prior to the repeal of Section 958(b)(4) may be a CFC in the inclusion year because of Section 958(b)(4) repeal, which allows the stock of such foreign corporation owned, for example, by a foreign parent to be attributed downward and constructively owned by a US subsidiary for purposes of determining the CFC status of the foreign corporation under Section 957.

Allocation and apportionment of deductions. Generally, the rules of Sections 861 through 865 apply to allocate and apportion deductions to the separate foreign tax credit limitation categories under Section 904(d), and for purposes of allocating and apportioning any deductible expense, any tax exempt asset (and income from such asset) is not taken into account. The Proposed Regulations provide that the Section 965(c) deduction allowed with respect to a Section 965(a) inclusion does not result in any portion of the Section 965(a) inclusion being treated as exempt income within the meaning of Section 864(e)(3) or the regulations thereunder. Similarly the stock of a DFIC with respect to which the Section 965(a) inclusion is recognized does not result in the treatment of such stock as an exempt asset. The Proposed Regulations also provide that neither the Section 965(a) PTI nor Section 965(b) PTI are treated as giving rise to exempt, excluded, or eliminated income.

Prop. Reg. Section 1.965-7: Elections and payment of Section 965 transition tax

Section 965(h) and the Proposed Regulations provide that any taxpayer may elect to pay its 965(h) net tax liability in installments over eight years: 8% for the first 5 years, 15% in year 6, 20% in year 7, 25% in year 8. The first installment, and each succeeding installment, is due on the due date, without regard to extensions, for the tax year of the installment. Payment of any unpaid portion of the remaining installments will become immediately due if certain acceleration events occur. Acceleration events are: (1) failure to timely pay an installment; (2) a liquidation, sale, exchange, or other disposition of substantially all of the assets of the person; (3) for persons other than individuals, a cessation of business; (4) any event resulting in the person no longer being a US person; (5) in the case of a person that was not a member of any consolidated group, becoming a member of a consolidated group; and (6) in the case of a consolidated group, the group ceasing to exist; Events (4), (5), and (6) are new (i.e., not included in Section 965(h)(3) and not previously announced). There are exceptions for acceleration events that primarily relate to events that occur between members of a consolidated group and require a transfer agreement to be filed within 30 days of the acceleration event with the Commissioner and included with both transferee and transferors returns. Deficiencies and/or additional Section 965(h) net tax liability will generally be prorated to the installments unless the deficiency or additional liability is due to negligence, intentional disregard of rules and regulations or fraud. This includes a situation when a person timely files a return increasing the amount of its Section 965(h) net tax liability above the amount taken into account in the payment of the first installment, or the person files an amended return increasing the amount of its Section 965(h) liability.

The Proposed Regulations provide that, in accordance with Section 965(n), a taxpayer may elect to not take in to account an applicable amount in determining its net operating loss under Section 172 for the year or in determining the amount of taxable income for the year that may be reduced by NOL carryforwards or carrybacks (note that the election will apply to both in their entirety). Consistent with Notice 2018-26, the Proposed Regulations provide that the applicable amount not taken into account is the taxpayer's Section 965(a) inclusion amount reduced by the Section 965(c) deductions plus the related Section 78 gross up (taxes deemed paid on the inclusion under Section 960(a)(1)). The election is irrevocable.

Both the Sections 965(h) and 965(n) elections must be made no later than the due date (taking into account extensions or additional time that would have been granted had the taxpayer requested an extension) for the tax return of the relevant tax year. The respective elections must be made by attaching a statement, signed under penalties of perjury, to the tax return for the relevant tax year. Relief is not available to make a late election.

Consistent with Notice 2018-13, the Proposed Regulations provide an election to determine the post-1986 E&P of a SFC as of the November 2, 2017, measurement date using the alternative method. Specifically, the alternative approach determines the amount of post-1986 E&P of a SFC (other than a SFC with a 52-53 week year) as of November 2, 2017, as the sum of: (1) the post-1986 E&P as of October 31, 2017, and (2) the annualized E&P amount computed as the amount equal to 2 multiplied by the daily earnings amount of the SFC based on the post-1986 E&P as of the close of October 31, 2017. The controlling domestic shareholder must make this election on behalf of the SFC by the due date, taking into account extensions, of the first tax year in which the shareholder has a Section 965(a) inclusion or takes into account an E&P deficit of the SFC. Relief is not available to make a late election. A SFC with a 52-53 week year may use the alternative method for both measurement dates.

The Proposed Regulations do not provide additional clarity on reporting the Section 965(h) net tax liability or payments on the taxpayers' corporate income tax return. The Proposed Regulations also do not address the IRS's position in its FAQs that states that taxpayers are not eligible for a refund of any 2017 overpayment unless and until the amount of payments exceeds the entire unpaid 2017 income tax liability, including all amounts to be paid in installments under Section 965(h) in subsequent years.

Prop. Reg. Section 1.965-8: Affiliated groups, including those that file consolidated returns

All members of a consolidated group that are US shareholders of a SFC are treated as a single US shareholder for purposes of determining the aggregate foreign E&P deficit amount with respect to all the US shareholders of such consolidated group under Section 965(b). Likewise, all such members are treated as a single shareholder for purposes of Sections 965(h), (k), and (n) relating to the election to pay the Section 965 net tax liability in installments, the extended statute of limitations, and the election to forgo the use of NOLs, respectively.

However, single US shareholder treatment does not apply for purposes of determining a US shareholder's Section 965(a) inclusion or whether a Section 960 credit is available to such a shareholder with respect to that inclusion. While such single US shareholder treatment is not provided for purposes of determining the deduction allowed under Section 965(c), the Proposed Regulations provide that the aggregate foreign cash position used to determine the deduction nevertheless is based on a consolidated group's cash ratio.

Section 965(b)(5) allows US shareholders that are members of the same affiliated group (as defined in Section 1504), but not members of the same consolidated group, to take into account the affiliated group's aggregate unused E&P deficit. Specifically, a US shareholder of an affiliated group that has an overall Section 965(a) inclusion amount with respect to all of the SFCs it owns (an E&P net surplus shareholder) is allowed to further reduce its overall Section 965(a) inclusion amount by its applicable share of the affiliated group's aggregate unused E&P deficit. An affiliated group's aggregate unused E&P deficit is determined by reference to only those US shareholders of the group (an E&P net deficit shareholder) that respectively have an aggregate foreign E&P deficit that exceeds their aggregate Section 965(a) earnings amount. The amount of the affiliated group's aggregate unused E&P deficit is the sum of such excess. The Proposed Regulations provide specific rules related to the application of Section 965(b)(5) and treat a consolidated group that is part of a larger affiliated group as a single US shareholder for purposes of Section 958(b)(4).

Proposed regulations under Section 986

The Proposed Regulations also provide rules on the application of Section 986(c) to Section 965(a) PTI and Section 965(b) PTI. Under the Proposed Regulations, and consistent with Notice 2018-13, the Section 986(c) gain or loss is determined based on movements in the exchange rate between December 31, 2017, and the time such distributions are made. Also under the Proposed Regulations, and consistent with Notice 2018-07, foreign exchange gain or loss recognized under Section 986(c) from the distribution of Section 965(a) PTI will be reduced proportionately by the amount of the deduction allowed against the inclusion to arrive at the transition tax rates. A new rule provided in the Proposed Regulations provides that Section 986(c) does not apply to distributions of Section 965(b) PTI.

Individual taxpayers

Section 962 provides an election (Section 962 election) for a US individual shareholder of a CFC to be taxed on the subpart F income inclusion of the CFC at the corporate rate of tax, and distributions from the CFC that otherwise may be non-taxable PTI would be taxable to the extent the amount of the distributions exceeded the amount of tax the individual paid with respect to the subpart F income inclusion. Notably Prop. Reg. Section 1.962-2(a) confirms that an US individual (including a trust or estate) who owns a DFIC through a domestic pass-through entity (e.g., a domestic partnership) may make the Section 962 election but only if the US individual is a US shareholder of the DFIC.

In addition, the Proposed Regulations adopt the rules described in Notice 2018-26 on the limitation of stock attribution from a less than 5% partner to a partnership for the purposes of determining whether a foreign corporation has a domestic corporation as a US shareholder. Also of interest to individual shareholders of DFICs, the Proposed Regulations provide that, for purposes of Section 1411, a Section 965(c) deduction is not treated as being properly allocable to any Section 965(a) inclusion and the Section 1411 net investment income tax is not payable via the installment method under 965(h). These issues and other related issues of interest to individuals, domestic partnerships and S corporations will be covered in detail as part of a forthcoming Tax Alert.

Applicability dates

Generally, the proposed regulations, when finalized as final regulations, apply beginning the last tax year of a foreign corporation beginning before January 1, 2018, and with respect to a US person, the tax year of such person in which or with which such tax year of the foreign corporation ends. The anti-avoidance rules of Prop. Reg. Section 1.965-4 apply regardless of whether the transaction, effective date of an entity classification election, or specified payment occurred before those dates.

Implications

The Proposed Regulations largely implement the rules described in the Section 965 Notices, but make certain material changes. As a result, taxpayers should reevaluate their Section 965 calculations. In many instances, taxpayers will need to determine the subpart F income of their SFCs as of each E&P measurement date to properly determine their Section 965(a) inclusion amounts. Taxpayers will also need to apply the new double-counting rule in Prop. Reg. Section 1.965-4(f) with respect to any specified payments occurring between November 2 and December 31, 2017. Foreign tax credit calculations should be revisited in light of the provisions that were not included in the Section 965 Notices and the US shareholders of E&P deficit foreign corporations will want to determine the impact of the basis adjustment election.

Income tax accounting considerations

Those companies that have not yet finalized their accounting for the transition tax using the guidance in Staff Accounting Bulletin No. 118 (SAB 118) may, as a result of the Proposed Regulations, adjust their estimates of the transition tax accrued in prior periods in order to continue to refine the amounts as new information becomes available as required by SAB 118. As a reminder, any provisional amounts or adjustments to provisional amounts included in a company's financial statements during the measurement period should be included in income from continuing operations as an adjustment to tax expense or benefit in the reporting period the amounts are determined.

If these Proposed Regulations were released after the date a company closed its books but before its financial statements are issued, a company that has accounted for the related provisions of the Act as provisional under SAB 118 would generally not be required to adjust the provisional amounts in its current financial statements. However, a company may consider disclosing the effect of significant adjustments related to any guidance issued but not yet reflected in the company's financial statements.

To the extent a company has previously disclosed the accounting for enactment date effects of the transition tax as final, the Proposed Regulations may be evaluated under the uncertain tax position guidance in ASC 740-10-25-6. A change in judgment may result in the subsequent recognition, derecognition, or changes in measurement of a tax position that was previously recognized in a prior annual period (including any interest and penalties). Changes in judgment are generally considered a discrete event recognized in income from continuing operations in the period (interim as well as annual) in which the change occurs.

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Contact Information
For additional information concerning this Alert, please contact:
 
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Sue Lippe(312) 879-4254;
Jennifer Cobb(713) 750-1334;
Stephen Peng(202) 327-7471;
Trey Whitten(202) 327-7419;
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Angela Evans(404) 817-5130;
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