August 8, 2018 Federal proposed Section 965 transition tax regulations have state tax implications On August 1, 2018, the Treasury Department issued proposed regulations (REG-104226-18) (the Proposed Regulations), providing important guidance with respect to Section 965 of the Internal Revenue Code of 1986, as amended (IRC).1 Section 965, as amended by the "Tax Cuts and Jobs Act" (P.L. 115-97) (TCJA), generally imposes a one-time transition tax on a Section 958(a) US shareholder on certain previously untaxed post-1986 accumulated earnings of its relevant foreign corporate subsidiaries. Since nearly every state with a corporate or personal income tax relies upon the IRC in some manner, the Proposed Regulations will have important implications for reporting purposes for US state and local (collectively, state) personal, corporate and other business taxes. This Tax Alert focuses on the general effects of the Proposed Regulations on state corporate income taxpayers (i.e., C corporations), assuming they are finalized in their current form. It does not address the state income or other business tax consequences of the Proposed Regulations on any other type of taxpayer, including individuals and pass-through entities (such as partnerships, limited liability companies, or S corporations). Readers are cautioned that the impact of the Proposed Regulations on state corporate income taxpayers as described in this Tax Alert may not necessarily be the same impact that applies to other types of state taxpayers. Background Section 965 generally imposes a one-time transition tax on a US shareholder (as defined in Section 951(b)) on certain previously untaxed post-1986 accumulated earnings of its relevant foreign corporate subsidiaries. Relying upon existing provisions of Subpart F of the IRC (codified at Sections 951 to 965), Section 965 generally requires a special inclusion of such post-1986 accumulated earnings of a relevant foreign corporation in the subpart F income of its US shareholder, but it also provides certain deductions depending upon the nature of those earnings for the purpose of imposing the transition tax at lower effective tax rates than would otherwise apply. Section 965 provides complicated allocation and netting rules to compute the relevant Section 965 amounts of a taxpayer or group of affiliated taxpayers. Both the statute and the Proposed Regulations provide complex, specialized treatment of the post-1986 accumulated earnings and deficits of affected foreign corporations depending upon whether their respective US shareholders are members of an affiliated or consolidated group and insert complex definitional issues that have to be carefully followed. From a definitional standpoint, the state complexities are exponentially magnified by whether the state will follow this definitional treatment or not. The following summarizes key aspects of Section 965: Section 965(a) earnings amount. Section 965(a) generally provides that the subpart F income of a specified foreign corporation (SFC) (defined to include either a controlled foreign corporation (CFC) or 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 income2 is referred to as a deferred foreign income corporation (DFIC). Finally, Section 951(a) provides that the pro rata share of the Section 965(a) earnings amount of a DFIC is generally included in the gross income of its US shareholder. Section 965(b) reduction in Section 965(a) earnings amount for foreign E&P deficits. Under Section 965(b), if a US shareholder owns at least one DFIC and at least one SFC with a deficit in post-1986 E&P (referred to as an E&P deficit foreign corporation), then the pro rata share of the Section 965(a) earnings amount of a DFIC that would otherwise be included in the gross income of its US shareholder under Section 951(a)(1) is generally reduced by the amount of such US shareholder's aggregate foreign E&P deficit that is allocated to such DFIC (such resulting reduced amount is referred to as the US shareholder's Section 965(a) inclusion amount, which cannot be less than zero). The aggregate foreign E&P deficit with respect to any US shareholder is generally the aggregate of such shareholder's pro rata shares of the relevant E&P deficits of the E&P deficit foreign corporations of such shareholder. In addition, Section 965(b)(5) generally allows US shareholders that are members of the same affiliated group (as defined in Section 1504) to take into account the affiliated group's aggregate unused E&P deficit (effectively a netting process among US shareholders in the same Section 1504 affiliated group).3, 4 Section 965(c) deduction amount. Under Section 965(c), a US shareholder is generally 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. Liability payable over eight years. Once the US shareholder's transition tax amount is determined, Section 965(h) generally permits such taxpayers to elect to pay the transition tax liability so determined in eight annual installments. IRS frequently asked questions. On March 13, 2018, the IRS issued informal guidance5 in the form of answers to frequently asked questions (the 965 FAQs) to enable US shareholders to report the transition tax on their 2017 federal income tax returns. Perhaps most important for state tax purposes, the 965 FAQs made clear that all of these determinations and the components of the transition tax for a corporate taxpayer will essentially be reported on a separate "IRC 965 Transition Tax Statement" that is attached to the corporation's 2017 federal income tax return.6 Thus, under the 965 FAQs, the components of the transition tax are reported "off the return" since the Section 965 amounts will not be included in the calculation of a corporate taxpayer's taxable income on Page 1 of the IRS Form 1120. For more information on the federal income tax treatment of the transition tax and the 965 FAQs, see Tax Alert 2017-2166 and Tax Alert 2018-0602. For more information on the state tax implications of the transition tax and the 965 FAQs, see Tax Alert 2017-2171 and Tax Alert 2018-0622. Proposed Regulations The Proposed Regulations include, with certain modifications, the provisions announced in three prior IRS Notices7 (Section 965 Notices), one revenue procedure,8 various 965 FAQs, and IRS Publication 5292, How to Calculate Section 965 Amounts and Elections Available to Taxpayers. The Proposed Regulations not only implement the rules described in the Section 965 Notices, but also provide additional rules to facilitate: — Determinations of foreign tax credits associated with Section 965 inclusions and distributions of previously taxed E&P created by Section 965 — Adjustments to E&P and stock basis of SFCs — The netting of E&P surpluses and deficits of members of affiliated groups, including members of affiliated groups that have elected to join in filing federal consolidated returns — The treatment of transactions among affected corporations, including DFICs and SFCs, accounting method changes and entity-classification elections that will be disregarded for purposes of Section 965 — Determinations of subpart F income otherwise earned by foreign corporations during the inclusion year and excluded from treatment under the transition tax — Expense allocation and apportionment related to Section 965 transition tax amounts From a state corporate income tax perspective, the guidance provided in Prop. Reg. Section 1.965-8, Affiliated groups (including consolidated groups), is of particular interest and appears to take a narrower and precise approach to the treatment of offsetting items among members of affiliated or consolidated groups than was set out in Notice 2018-07. Under Prop. Reg. Section 1.965-8(e), all members of a consolidated group (as defined in Reg. Section 1.1502-1(h)) that are US shareholders of a SFC are generally treated as a single US shareholder for purposes of Section 965(b) and Prop. Reg. Section 1.965-1(b)(2) relating to the reduction in the Section 965(a) earnings amount for foreign E&P deficits (hereafter referred to as "single US shareholder treatment"). With respect to the netting process in Section 965(b)(5) that allows US shareholders that are members of the same Section 1504 affiliated group to further take into account the affiliated group's aggregate unused E&P deficit, Prop. Reg. Section 1.965-8(b) and (c) provide specific rules related to the application of Section 965(b)(5) by further treating a consolidated group as a single member of the affiliated group when some, but not all, members of an affiliated group are members of a consolidated group (hereafter referred to as "single member treatment"). These precise definitional issues are expected to be magnified at the state level where challenges will exist as to whether the state regimes will follow consolidated or affiliated treatment as described in more detail below. Likewise, under the Proposed Regulations, all members of a consolidated group are generally treated as a single person for purposes of paragraphs (h), (k), and (n) of Section 965 and Prop. Reg. Section 1.965-7 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 net operating losses, respectively (hereafter referred to as "single person treatment"). However, the Proposed Regulations provide that this single US shareholder treatment generally does not apply for purposes of determining a US shareholder's pro rata share of the Section 965(a) earnings amount of a DFIC that is included in such US shareholder's gross income under Section 951(a)(1), nor does it apply in determining whether a federal foreign tax credit (FTC) under Section 960 is available to such US shareholder with respect to that inclusion. Such single US shareholder treatment also does not apply for purposes of determining the deduction allowed under Section 965(c); however, 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 (hereafter referred to as the "consolidated cash ratio").9 There are several other issues addressed by the Proposed Regulations that may also be of particular interest to state corporate income taxpayers. For example, the Proposed Regulations provide basis adjustments to be made to stock held by a US shareholder in a SFC or applicable property with respect to the SFC, as well as various adjustments to be made to relevant E&P. In addition, Prop. Reg. Section 1.965-8(d)(2) refers members of consolidated groups to Reg. Section 1.1502-33(d)(1) for adjustments to E&P, and to Reg. Section 1.1502-32(b)(3) for adjustments to basis. Further, the Proposed Regulations also address the allocation and apportionment of deductions for purposes of computing the federal FTC limitation, which is reported on IRS Form 1118. Of course, for state corporate income tax purposes, most states do not follow the federal consolidated return Regulations (such as Reg. Sections 1.1502-33 or -32), nor do they follow the federal FTC limitations, thus setting up the possibility of ambiguities and uncertainties with respect to the application of these regulatory computations for state purposes, even in states that follow combined reporting but do not incorporate such federal consolidating principles. For an in-depth federal income tax discussion of these rules and the other provisions contained in the Proposed Regulations, see Tax Alert 2018-1571. States' responses to Section 965 State approaches to whether and to what extent the transition tax amounts determined under Section 965 will be subject to that state's income tax (and whether, similar to federal law, the state will allow installment payments of the determined Section 965 transition tax amounts) vary broadly. These state approaches have been influenced or evidenced by legislative and regulatory action, administrative guidance, and tax return instructions since the enactment of the TCJA. In evaluating these approaches, the question is not merely whether a state conforms to Section 965, but also how the state conforms. Such conformity considerations include, but are not necessarily limited to, the following: — Whether the state's tax law generally conforms to the IRC as of December 22, 2017, the date of enactment of the TCJA, and thereby whether, as a threshold matter, any of the elements of the transition tax are included in the state tax base of a US shareholder — Whether the state's tax law provides a specific exclusion or deduction for the amounts determined under Section 965 — Whether the state's tax law decouples from or disallows the deductions allowed under Section 965(c) — Whether the state's tax law has an expense disallowance rule related to nontaxable income — Whether the state's tax law incorporates the election under Section 965(h) to pay the transition tax in eight annual installments More than a dozen states include at least a portion of the Section 965 amounts in state taxable income simply by virtue of how they impose their corporate income tax on subpart F income. In many of these states, subpart F income is treated as if it were dividend income. For example, Kansas's income tax law allows corporations to subtract an amount equal to 80% of dividends received from corporations incorporated outside of the United States or the District of Columbia, and the remaining 20% of such dividend income is included in the Kansas income tax base.10 Among those states that provide a full deduction or exclusion of Section 965 income, approximately one-third require corporations to add back to taxable income expenses attributable, or deemed attributable, to nontaxable income, which can result in unexpected increases in a taxpayer's state income tax liabilities. At least a dozen states have enacted legislation addressing conformity issues pertaining to Section 965. For instance, both New York State and New York City amended existing laws to treat as "exempt CFC income" amounts that are included in federal gross income pursuant to Section 951(a) by reason of Section 965(a) (as adjusted by Section 965(b)) but without any adjustment for Section 965(c). The North Carolina legislature also amended its state corporate income tax law to include a subtraction modification for any amount included in federal taxable income under Section 965 and a corresponding addition modification for the amount deducted under Section 965(c), thereby eliminating the transition tax amounts from its corporate income tax base entirely. Similarly, the Georgia legislature amended its corporate tax law to provide that deductions, exclusions or subtractions provided by Section 965 do not apply to the extent the related income has been subtracted as a deemed dividend received. The Oklahoma legislature, on the other hand, enacted amendments to its corporate tax law, which only address the installment payment election under Section 965(h), providing in effect that if a US shareholder elects to pay its federal transition tax in eight annual installments, it can do so for Oklahoma income tax purposes as well. In addition to these states, and as of the date of this Tax Alert, other states that have enacted statutory provisions directly responsive to Section 965 include: Connecticut, Hawaii,11 Idaho, Indiana, New Jersey, Oregon, Utah and Wisconsin. The Oregon legislature approached the Section 965 transition tax in a slightly different manner. Oregon's tax law had previously included the income of tax haven corporations in the combined income of an Oregon consolidated reporting group. Recognizing that by conforming to the transition tax such income had previously been subject to Oregon corporate income tax, the Oregon legislature chose to eliminate its taxation of tax haven corporations entirely. As a result, with respect to the Section 965 income that is included in the consolidated reporting group's taxable income subject to the state's dividends received deduction (DRD) rule, the state provided a credit mechanism for the tax impact attributable to relevant tax haven income.12 More than 15 state taxing authorities have provided guidance on how to report Section 965 income for state tax purposes. The guidance ranges in scope and demonstrates a broad exercise of administrative authority. In some cases, the states address the impact of the transition tax for state tax purposes for one or more different types of taxpayers. For example, some of these states have offered guidance on how the transition tax applies for state tax purposes for taxpayers that are corporations, individuals, pass-through entities, fiduciaries or trusts. Still others have provided guidance on important state tax issues unrelated to the direct conformity with the determination of the transition tax amounts and somewhat unique to state tax matters generally. For example, taxpayer publications from state revenue departments have addressed how the state will or will not conform to the installment payments permitted for federal income tax purposes, as well as unique state considerations as to how the transition tax amounts will or will not be included in the computation of state apportionment factors. In many cases, these states have issued new administrative policies. Examples of this type of state guidance is described below: — The Alabama Department of Revenue provided a detailed schedule to enable taxpayers to prepare the computations and reporting related to state modifications of Section 965 amounts. — The Alaska Department of Revenue provided guidance in its corporate tax form instructions for the 2017 tax year, without issuing any separate advisory publications to corporate taxpayers. — Arizona's guidance to date addresses fiduciary returns. — The California Franchise Tax Board issued guidance stating that its corporate tax law does not conform to Section 965 and, consequently, instructs California taxpayers that report Section 965 amounts on their federal income tax returns to make corresponding adjustments on their California corporate franchise tax returns to recognize these differences between California and federal tax law. — Massachusetts guidance provides penalty relief for underpayments of estimated tax attributable to Section 965 transition tax amounts. — Both the Michigan Department of Treasury and the Pennsylvania Department of Revenue published guidance that outlines the statutory support for their interpretation of the application of Section 965 for purposes of both their corporate and personal income taxes. — The New York Department of Taxation and Finance has issued three notices on reporting the transition tax amounts under Section 965 — Important Notices N-18-8 (for flow-through entities), N-18-7 (for corporations, insurance corporations and exempt organizations), and N-18-4 (for individuals). — The Rhode Island Division of Taxation (RI DOT) adopted a regulation13 generally holding that the transition tax amounts under Section 965 are includable in Rhode Island corporation taxable income, subject to new rules regarding qualification for a DRD. The state's rules deviate from its current policy regarding the taxation of subpart F income (e.g., subpart F income as defined in Section 952). In addition, the RI DOT separately issued administrative guidance on the Rhode Island tax treatment of Section 965 income for individuals, partnerships, limited liability companies, fiduciaries and S corporations. — Tennessee, among other states, has included guidance as to how the Section 965 transition tax amounts reported affect the taxpayer's apportionment to the state. Taxpayers also should be aware that some state Section 965 guidance was issued prior to subsequent enactment of state tax law changes to the treatment of the transition tax and, thus, such initial guidance may be superseded by enacted law. For instance, the initial Section 965 guidance issued by the Connecticut Department of Revenue Services (CT DRS), which was based on then-pending legislation, instructed taxpayers that 10% of their Section 965 amounts would be includible in their Connecticut taxable income based upon the then-pending version of Connecticut Senate Bill 11 (SB 11). SB 11, as finally enacted on May 31, 2018, however, provided that the applicable percentage was only 5%, and the CT DRS quickly updated its previously-issued guidance to reflect the final legislative change. Similarly, in March 2018, the New Jersey Division of Taxation (NJ DOT) issued guidance in which it concluded that for New Jersey Corporate Business Tax (CBT) purposes, amounts reported under the transition tax would be treated as dividends subject to the state's DRD rules and, for an 80%-or-more owner of a foreign corporation, would be completely excluded from entire net income (ENI). (That same guidance also pointed out that corporations that owned less than 80% of the stock of the foreign corporation would be eligible for a reduced DRD for New Jersey CBT purposes.) This guidance is now superseded by statute. On July 1, 2018, New Jersey Gov. Phil Murphy signed into law AB 4202 (enacted as 2018 N.J. Laws Chapter 48), which significantly changed the New Jersey CBT law and now requires the retroactive inclusion of the post-1986 E&P of foreign subsidiaries required under Section 965 in New Jersey ENI and disallows all of the deductions, credits, and exemptions of that section, subject to a 95% DRD, as well as special apportionment provisions for such income for the 2017 tax year. As of August 8, 2018, the NJ DOT's March 2018 guidance has not yet been revised.14 This lack of update by New Jersey could result in taxpayers that are unaware of the legislative change to incorrectly report their Section 965-related liabilities. For more on how states have responded to the TCJA, see the State Income and Franchise Tax Quarterly for the first two quarters of 2018, available through Tax Alert 2018-0758 and Tax Alert 2018-1382. State corporate income tax implications of the Proposed Regulations We have previously highlighted a number of state corporate income tax considerations related to the state taxation of Section 965 income (see Tax Alert 2017-2171). The Proposed Regulations illuminate additional considerations regarding the state corporate income tax treatment of Section 965. Perhaps most important is the potential for significant differences between the federal and state corporate income tax treatment of the same Section 965 issue (for example, differences between consolidated versus separate return treatment or even between consolidated and combined reports where the membership may be significantly different, which we refer to as "disconnects"). A significant disconnect may arise from the single US shareholder treatment and single member treatment provisions in Prop. Reg. Section 1.965-8 relating to the impact of federal consolidated groups on Section 965(b) calculations, as well as the consolidated cash ratio provision relating to the impact of federal consolidated groups on Section 965(c) calculations. Of lesser importance, but still impactful, are the potential for federal/state disconnects attributable to the single person treatment provisions in Prop. Reg. Section 1.965-8 relating to the impact of federal consolidated groups on 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 net operating losses, respectively, which many states do not apply, even though they conform to the Section 965 provisions. Most separate reporting states (and some unitary combined reporting states) do not incorporate federal consolidated return concepts into their law. Moreover, oftentimes, the state combined reporting group members may not even be the same as that of the federal consolidated group. This means that while the states generally will follow federal income tax amounts impacted by definitional references to Section 1504, they oftentimes require the recalculation of federal income tax amounts impacted by the filing of federal consolidated returns or impacted by the corresponding application of the federal consolidated return Regulations for state tax purposes. For example, some separate company reporting states have enacted strict statutes requiring corporate taxpayers to use as their starting point federal taxable income that has been calculated as if the taxpayer filed a federal income tax return on a stand-alone basis, or they have instead enacted statutes or regulations specifically decoupling from the federal consolidated return Regulations. Accordingly, it is possible that some states might interpret the Proposed Regulations under their state tax regimes as requiring the recalculation of relevant federal amounts without application of the federal consolidated group provisions contained in Prop. Reg. Section 1.965-8. In the context of Section 965(b) calculations, for example, it could be problematic if a state were to decouple from single US shareholder treatment in a situation involving a federal consolidated group that has: (i) at least two US shareholders and (ii) at least one significant E&P deficit foreign corporation. Using this single US shareholder treatment conformity topic further as an example, this topic creates a variety of as yet unanswered questions that must be addressed in relevant states, including the following: — If single US shareholder treatment under Prop. Reg. Section 1.965-8 is viewed as a definitional rule, does that mean the states will follow the federal rule and not require recomputation of the relevant Section 965(b) amounts? What if one member of the federal consolidated group is a taxpayer in the state and the other member is not? What if the members are not unitary with each other? — If a state does not recognize single US shareholder treatment, will it require the taxpayer to recompute its Section 965(b)(2) amount disregarding the eligible items of the consolidated/affiliated members that are also US shareholders? In separate reporting states, would such computations only be allowed at the separate entity level? — If a state does not recognize single US shareholder treatment, will it similarly not recognize single member treatment and thereby require the recomputation of the E&P netting process among affiliated US shareholders under Section 965(b)(5)? — Do state tax laws today decouple from the Regulations, generally, and do those same laws decouple from the Proposed Regulations, specifically? — Since each state's taxing statute is unique and each state is sovereign, does this mean each state could approach these questions differently, such that the answers to each of the questions above could vary from state-to-state (and, moreover, from taxpayer-to-taxpayer, even within the same affiliated or federal consolidated group)? The answers to these questions may present time-sensitive compliance and reporting concerns since most calendar year-end corporations will file their extended state corporate income tax returns for the 2017 tax year this coming September through November. Furthermore, states that generally conform to TCJA provisions beginning in 2018 also may need to address the applicability of relevant Section 965 amounts in 2018 tax year returns, including the implications of the Proposed Regulations, since many taxpayers are expected to report relevant Section 965 amounts on their 2018 tax year returns. Most of these states have yet to address Section 965 conformity issues. (Recall that the year of recognition of relevant Section 965 amounts is not based on the US shareholder's tax year, but rather is based upon the last tax year of a DFIC that begins before January 1, 2018.) With respect to the Proposed Regulations' adjustments to E&P and stock basis, taxpayers should further be aware that many federal/state differences may arise in computing E&P or stock basis for state purposes, given disconnects between federal and state tax law due to a state's general IRC conformity date or specific conformity rules (or both). Taxpayers should recognize that these federal/state disconnects could result in disparate federal and state tax treatment of future distributions and stock sales, and such differences could be significant. Finally, with respect to the Proposed Regulations' guidance surrounding the allocation and apportionment of deductions for purposes of computing the federal FTC limitation (which is reported on IRS Form 1118), states have, under audit, examined taxpayer Forms 1118 to determine the portion of expenses that are disallowed as a state deduction by virtue of being attributable to nontaxable or exempt categories of foreign income. Thus, state tax liabilities may be impacted by how or whether amounts attributable to Section 965 are taken into account for purposes of the federal FTC limitation. Few states actually recognize FTCs themselves and, consequently, disparities could exist between the federal and state tax treatment of these allocations. Looking beyond state conformity A number of state tax considerations beyond IRC conformity remain worthy of exploration. As a threshold matter, taxpayers should question whether states can impose tax on Section 965 income in light of US Constitutional limitations, especially under the Foreign Commerce Clause.15 Moreover, taxpayers should ask what connection, if any, does Section 965 income have to a state that allows such income to be subject to state taxation. Assuming the states can impose tax in this way, questions arise regarding the nature of Section 965 income and subpart F income generally for state corporate income tax purposes. For example, do these items of income constitute so-called "deemed dividends" that should be treated by states in the same manner as dividends actually distributed, and is such income treated as allocable or apportionable? States provide little, if any, statutory or administrative guidance regarding the sales apportionment factor implications — including factor representation (in the sales factor denominator) and sourcing (to the sales factor numerator) — for dividends or subpart F income that constitute apportionable business income. Given these and other questions posed by the enactment of the TCJA, state taxing authorities can be expected to issue guidance not only as to whether their states will conform to Section 965, but also to provide taxpayers with valuable guidance as to how Section 965 amounts should be reported on state income tax returns. EY will continue to follow state legislative sessions in which state lawmakers, often with the help of state taxing authorities, are considering conformity to the TCJA provisions, and we will provide updates on these state responses as they become available. ———————————————
——————————————— 1 Except as otherwise indicated, all references herein to "Section" are to the relevant section or sections of the IRC, and references to "Reg. Section" are to the relevant section or sections of the Income Tax Regulations promulgated by the Treasury Department under the IRC (Regulations). In addition, "IRS" means the Internal Revenue Service. 2 A SFC's accumulated post-1986 deferred foreign income generally equals its post-1986 earnings and profits (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 and subject to tax under the IRC or that if distributed would be excluded from the gross income of a US shareholder under the Section 959 exclusion for previously taxed E&P. The post-1986 E&P of a SFC generally 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. 3 Specifically, a US shareholder (of an affiliated group) that has an overall positive Section 965(a) inclusion amount with respect to all of the SFCs it owns (referred to as an E&P net surplus shareholder) is allowed to further reduce its overall Section 965(a) inclusion amount (but not below zero) by its applicable share of the affiliated group's aggregate unused E&P deficit. An affiliated group's aggregate unused E&P deficit is generally determined by reference to only those US shareholders of the group (referred to as E&P net deficit shareholders) 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 generally the sum of the excesses of each E&P net deficit shareholder in the affiliated group. 4 In general terms, the effect of the Section 965(b) reduction calculation is first to allocate a US shareholder's SFC E&P deficits among that US shareholder's pro rata shares of the accumulated post-1986 E&P of its DFICs. If, as a result of this first step, a US shareholder has a net E&P deficit remaining, it is an E&P net deficit holder, whose net deficit can then be netted against an affiliated US shareholder that is an E&P net surplus shareholder. In summary, E&P deficits first offset E&P surpluses within a US shareholder's population of relevant SFCs (under Section 965(b)(1)-(2)), and then the resulting E&P net deficits of affiliated US shareholders subsequently offset the resulting E&P net surpluses among the other affiliated US shareholders (under Section 965(b)(5)). 5 IRS News Release IR-2018-53, IRS provides additional details on section 965, transition tax; Deadlines approach for some 2017 filers (March 13, 2018) (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. 6 965 FAQs #3. 7 Notice 2018-07 (issued on December 29, 2017) announced the intended general scope and direction of certain regulations the Treasury Department intended to issue addressing Section 965. It also indicated that the Treasury Department intended to issue Regulations providing that, solely with respect to the calculation of the amount included in gross income by a consolidated group (as defined in Reg. Section 1.1502-1(h)) under Section 951(a)(1) by reason of Section 965(a), all of the members of a consolidated group that are US shareholders of one or more SFCs would be treated as a single US shareholder (see Tax Alert 2017-2232). Notice 2018-13 (issued on January 19, 2018) stated that the Treasury Department and IRS intended to issue rules addressing the calculation of earnings, including targeted relief for taxpayers from a change to the stock attribution rules. Notice 2018-26 (issued on April 2, 2018) described forthcoming rules intended to prevent avoidance of the effect of Section 965, relating to certain special elections, and on the reporting and payment of the transition tax. 8 Revenue Procedure 2018-17 (see Tax Alert 2018-0366). 9 In other words, for purposes of determining the Section 965(c) deduction amount of any US shareholder that is a member of a consolidated group, the aggregate foreign cash position of the US shareholder is equal to the aggregate Section 965(a) inclusion amount of the US shareholder multiplied by the group cash ratio of the consolidated group. Prop. Reg. Section 1.965-8(e)(3). 10 Kan. Stat. Ann. Section 79-32,138(c)(v). 11 Hawaii corporate income tax law previously decoupled from Sections 861 through 999 (which generally correspond to the IRC's international tax provisions, including the transition tax under Section 965). Thus, upon updating its IRC conformity date, Hawaii's corporate income tax law decouples from the amendments to Section 965, added by the TCJA, relating to the transition tax. 12 Or. Laws 2018, Chap. 101 (enacted April 10, 2018). The Oregon Department of Revenue has since adopted Or. Admin. R. 150-317-0651 13 280-RICR-20-25-15 (effective August 22, 2018). 14 The guidance is posted on the NJ DOT's website (last accessed on Aug. 8, 2018). On August 8, 2018, the webpage listed a last updated date of March 16, 2018, thus, not contemporaneous with the New Jersey legislature's revision to its corporate business tax law, which included both combined reporting and substantial changes to its treatment of Section 965. 15 In Kraft General Foods, Inc. v. Iowa Dept. of Rev. & Fin., 505 U.S. 71 (1992), the US Supreme Court held that Iowa violated the Foreign Commerce Clause of the US Constitution and unconstitutionally discriminated against foreign commerce by taxing dividends received from foreign subsidiaries differently than dividends received from domestic subsidiaries. (But see, however, E. I. du Pont de Nemours & Co. v. State Tax Assessor, 675 A.2d 82 (Maine, 1996) and Appeal of Morton Thiokol, Inc., 864 P.2d 1175 (Kansas, 1993) in which the highest courts of these two states distinguished the differential treatment of foreign corporate dividends within a unitary group. Neither of these two cases was ever appealed to the US Supreme Court.) | |||||||||||||||||||||||||||||
| |||||||||||||||||||||||||||||
