August 9, 2018 Proposed Section 965 regulations have implications for S corporations, partnerships and individuals On August 1, 2018, the Treasury Department issued proposed regulations (REG-104226-18) under Sections1 962, 965 and 986 (Proposed Regulations). As amended by Section 14103 of the Tax Cuts and Jobs Act, P.L. 115-97 (2017), Section 965 applies in the case of the last tax year of a deferred foreign income corporation (DFIC) that begins before January 1, 2018. The IRS and the Treasury Department have previously issued guidance announcing regulations intending to be issued under Section 965 in Notice 2018-07, 2018-4 I.R.B. 317, Notice 2018-13, 2018-6 I.R.B. 341, and Notice 2018-26, 2018-16 I.R.B. 40 (collectively, the Notices).2 The Proposed Regulations include, with certain modifications, the provisions previously announced in the Notices. Purpose of this Tax Alert This Tax Alert will provide an overview of how the Proposed Regulations affect taxpayers investing through domestic and foreign pass-through entities, including partnerships, S corporations, trusts, and estates, as well as individuals. Specifically, this Tax Alert will cover adjustments to basis under Prop. Reg. Section 1.965-2, the anti-avoidance rules of Prop. Reg. Section 1.965-4, foreign tax credits under Section 965(g), Section 965(h) installment elections, and Section 965(i) S corporation elections. Finally, this Tax Alert will address the modifications to the Section 962 regulations as they apply to Section 965. A detailed discussion of provisions not covered in this Tax Alert can be found in Tax Alert 2018-1571. An Overview of Section 965 Section 965(a) generally provides that the subpart F income of a specified foreign corporation (SFC) (i.e., a controlled foreign corporation (CFC) (within the meaning of Section 957)) and any other foreign corporation that has a 10% corporate United States shareholder in its tax year that begins before January 1, 2018 (such year, the inclusion year) is increased by the greater of its accumulated post-1986 deferred foreign income determined on November 2, 2017, and December 31, 2017 (the Section 965(a) earnings amount and the inclusion dates, respectively) (the tax resulting from such increase, the Transition Tax). An SFC that has accumulated post-1986 deferred foreign income is referred to as a deferred foreign income corporation or a DFIC. Generally, a US shareholder (a US shareholder within the meaning of Section 951(b)) only has a Section 965(a) inclusion with respect to the stock of an SFC, a DFIC, or an E&P deficit foreign corporation that they own, directly or indirectly, pursuant to Section 958(a).3 The Proposed Regulations refer to such US shareholders as "Section 958(a) US shareholders" and such stock as "Section 958(a) stock." An 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 an SFC equals E&P accumulated in years ending after December 31, 1986, but only during periods in which the foreign corporation was an SFC, and by diminution for dividends made during the inclusion year to other SFCs. Prop. Reg. Section 1.965-2: Adjustments to basis The Proposed Regulations provide rules, and an elective regime, to adjust a Section 958(a) US shareholder's basis in Section 958(a) stock of a DFIC or the "applicable property" of such shareholder. "Applicable property" is property owned directly by the US shareholder, including through foreign pass-through entities, through which a US shareholder is considered a Section 958(a) US shareholder of an SFC. The basis adjustments set forth in the Proposed Regulations apply to any Section 958(a) stock owned by a domestic pass-through entity. Where the domestic pass-through entity holds its interest in a DFIC through a chain of foreign entities, each foreign entity should increase its basis in the stock of the lower-tier foreign entity through which the domestic pass-through entity has a Section 965(a) inclusion. The Proposed Regulations do not specifically provide that adjustments should be made with respect to a domestic pass-through owner's interest in a domestic pass-through entity that owns Section 958(a) stock. Rather, adjustments to a domestic pass-through owner's basis in a domestic pass-through entity should be determined under the provisions of Subchapter K or Subchapter S, as applicable. Similarly, adjustments should be made to a partner's capital account under Section 704 and the accumulated adjustments account of any S corporations to reflect a partner's or S corporation shareholder's inclusion of a Section 965 amount. Prop. Reg. Section 1.965-3 refers to the aggregate foreign cash position of a Section 958(a) US shareholder for purposes of the deduction under Section 965(c). As a result, where the Section 958(a) US shareholder is a domestic pass-through entity, the Section 965(c) deduction is determined with respect to the aggregate foreign cash position of the domestic pass-through entity. A domestic pass-through owner should be allocated its pro rata share of the domestic-pass through entity's Section 965(c) deduction and reduce its basis in the domestic pass-through entity to reflect the allocation of such deduction. Key takeaways: — A US shareholder increases its basis in the stock of an SFC or DFIC owned within the meaning of Section 958(a), or the "applicable property" through which the shareholder is treated as a Section 958(a) US shareholder, for the US shareholder's pro rata share of such foreign corporation's Section 965(a) amount. — The proposed regulations provide for a corresponding increase or decrease in an upper-tier foreign entity's tax basis in a lower-tier foreign entity, SFC, DFIC, or E&P deficit foreign corporation through which a Section 958(a) US shareholder owns Section 958(a) stock. — Adjustments to a domestic pass-through owner's tax basis, partnership capital account, and accumulated earnings account of a domestic pass-through entity are determined under the relevant provisions of Subchapter K or S, as applicable. Prop. Reg. Section 1.965-4: Anti-avoidance Consistent with Notice 2018-26, the Proposed Regulations provide that certain transactions, including method changes and entity classification elections, will be disregarded for purposes of applying Section 965 to a US shareholder. A transaction may be disregarded for purposes of determining a US shareholder's Section 965(a) inclusion amount, the aggregate foreign cash position of an SFC, and the amount of foreign income taxes of an SFC deemed paid by the US shareholder under Section 960 as a result of a Section 965(a) inclusion (each a Section 965 element) if: — The transaction occurs, in whole or in part, on or after November 2, 2017. — The transaction is undertaken with a principal purpose of changing the amount of a Section 965 element of the US shareholder. — The transaction would, without being disregarded, change the amount of the Section 965 element of the US shareholder. Certain transactions (including any disposition of stock or property, such as a sale or exchange, contribution, distribution, issuance, redemption, recapitalization or other direct or indirect transfer) are presumed to be undertaken with a principal purpose of changing the amount of a Section 965 element of a US shareholder. These transactions include: 1) cash reduction transactions; 2) E&P reduction transactions; and 3) pro rata share reduction transactions. The Proposed Regulations also continue to disregard any entity classification election or change in method of accounting made for a tax year of an SFC that ends in 2017 or 2018 if the change in classification or method would change the amount of any Section 965 element with respect to the US shareholder, regardless of whether the method change is from an impermissible to a permissible method. A principal purpose of changing a Section 965 element is not required for the IRS to disregard an entity classification election or method change. Key takeaways — Any transaction closed after November 2, 2017, with respect to a Section 958(a) US shareholder's interest in any SFC, DFIC, or E&P deficit foreign corporation should be closely reviewed regardless of whether a principal purpose of the transaction was to impact a shareholder's Section 965(a) amount. Prop. Reg. Sections 1.965-5 and -6: Foreign tax credits Section 965(g)(1) and (3), respectively, disallow a foreign tax credit under Section 901 and any 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 of a taxpayer's foreign tax credit disallowance is proportionate to the deduction afforded under Section 965(c) for the associated income. Although a portion of the foreign tax credits and deduction associated with the Section 965(a) inclusion amount is disallowed, the Section 78 gross up amount is similarly reduced. 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. The Proposed Regulations also explicitly disallow 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. A domestic corporation may claim deemed paid foreign tax credits associated with such corporation's share of a domestic pass-through entity's Section 965(a) inclusion amount. When a deemed paid credit is claimed, the associated Section 78 gross up is proportional to the domestic corporation's Section 965(a) inclusion from the domestic pass-through entity. Key takeaways — The disallowance of the "applicable percentage" prevents taxpayers from taking a credit or deduction for foreign taxes paid attributable to the Section 965(c) deduction. — When an SFC makes a distribution of E&P that was previously taxed under Section 965, the applicable percentage of any foreign withholding tax imposed at the time of the distribution will similarly be disallowed. — Domestic pass-through entities must provide their owners with information regarding the associated foreign tax credit and the applicable percentage that is disallowed because the calculation of the applicable percentage is determined at the level of the domestic pass-through entity. Prop. Reg. Section 1.965-7(b): Eight-year installment election Section 965(h) allows a US shareholder of a DFIC to elect to pay the net Section 965 tax liability over eight years through installment payments with no interest charge (such election, the 8-year installment election). The Proposed Regulations provide specific instructions for taxpayers (i.e., Section 958(a) US shareholders or domestic pass-through owners of domestic pass-through entities that are Section 958(a) US shareholders) to make the 8-year installment election and prevent acceleration of payment in certain circumstances. The 8-year installment election is made with respect to the Section 965(h) net tax liability of a taxpayer. The Section 965(h) net tax liability is the taxpayer's total net tax liability under Section 965 reduced by the aggregate amount of the taxpayer's Section 965(i) net tax liabilities (i.e., amounts deferred under Section 965(i)). The 8-year installment election may be made by any taxpayer with a Section 965(h) net tax liability, but may not be made by a domestic pass-through entity. The Proposed Regulations specify that if an adjustment to the Section 965(h) net tax liability arises as a result of: (1) an assessed deficiency; (2) filing a return with an increase in the amount beyond what was taken into account in paying the first installment; or (3) filing an amended return that reflects an increase, such additional amount will be prorated among the installments. If the due date for an installment has passed, the payment will be due upon notice and demand. If the due date for the installment has not passed, the payment will be due with the installment. Consistent with the statute, the Proposed Regulations identify acceleration events that will cause any outstanding installment payments to be due, including an addition to tax for failure to timely pay an installment (except for the first installment), a liquidation or sale of substantially all of the assets of the person, or a cessation of the taxpayer's business. The Proposed Regulations add additional acceleration events including death and ceasing to be a US person. The due date for all remaining installments is the date of the acceleration event, which may be extremely difficult to meet in the case of death and may be impossible in the case of an individual who takes a position on his income tax return to be treated as a non-US person pursuant to a treaty. Gifts or sales of less than "substantially all" of a taxpayer's assets do not appear to be acceleration events. The Proposed Regulations provide an exception (the "eligible Section 965(h) transferee exception") pursuant to which the acceleration provisions of Section 965(h)(3) and Prop. Reg. Section 1.965-7(b)(3)(ii) do not apply. An acceleration event that occurs by reason of a liquidation, sale, exchange, or other disposition of substantially all of the assets of the person is a "covered acceleration event" provided the transferee is not a domestic pass-through entity and the transferee acquires substantially all of the assets from the transferor. In the case of "covered acceleration events," an eligible transferee may assume liability for the remaining installment payments. Death and ceasing to be a US person are not "covered acceleration events." Based on the definition of "pass-through entity,"4 questions may arise as to whether complex trusts will be treated as eligible Section 965(h) transferees. The eligible transferor and eligible transferee must enter into an agreement with the Commissioner within 30 days of the acceleration event in order for the transfer to be treated as a covered acceleration event. A detailed list of items to include in this agreement is provided for in Prop. Reg. Section 1.965-7(b)(4). Finally, the Proposed Regulations also make clear that the 8-year installment election applies only to the regular tax liability and does not apply to any Section 1411 net investment income tax (NIIT) liability. Therefore, the NIIT liability must be paid by the due date (not including extensions) of the tax return for the tax year in which the taxpayer incurred the Section 965(a) inclusion. Key takeaways — The 8-year installment election may be made by any taxpayer with a Section 965(h) net tax liability, but may not be made by a domestic pass-through entity. — The 8-year installment election does not apply to the NIIT. — Acceleration events cause the unpaid portion of the installment payments to be due on the date of the acceleration event. — Ceasing to be a US person is an acceleration event. Liquidating a trust (or distributing "substantially all" of its assets) is an acceleration event. — In the case of a "covered acceleration event," the transfer agreement that prevents acceleration of the unpaid installment payments must be filed with the Commissioner within 30 days of the transfer. Prop. Reg. Section 1.965-7(c): S corporation election Section 965(i) allows a shareholder of an S corporation that is a US shareholder of a DFIC to elect to defer payment of the shareholder's net tax liability under Section 965 with respect to the S corporation until the shareholder's tax year in which a triggering event occurs with respect to such liability (S corporation deferral election). An S corporation deferral election must be made no later than the due date (taking into account extensions, if any) for the S corporation shareholder's return for the tax year that includes the last day of the tax year of the S corporation in which the S corporation has a Section 965(a) inclusion to which a shareholder's Section 965(i) net tax liability is attributable. The S corporation deferral election is made by attaching a statement, signed under penalties of perjury, to the taxpayer's return for that year. The amount of tax that may be deferred is determined based on the "with and without" calculation used under Section 965(h)(6). However, when performing the "with and without" calculation for purposes of computing the Section 965(i) net tax liability, the only amounts taken into account are Section 965(a) inclusions arising from an S corporation, provided the S corporation is a US shareholder of the DFIC generating the inclusion. This means that if the S corporation is not a US shareholder of a DFIC (for example, because the S corporation owns less than 10% of the DFIC) then the S corporation deferral election is not available for those amounts. Similar to the 8-year installment, the S corporation deferral election does not apply to the NIIT. The Proposed Regulations implement an annual reporting requirement until the Section 965(i) net tax liability is fully paid. If a shareholder fails to report the deferred amount by the due date of the return (including extensions), then 5% of the deferred Section 965(i) net tax liability will be assessed as an addition to tax for that tax year. In the case of a triggering event, any Section 965(i) net tax liability will be assessed as an addition to tax for the shareholder's tax year in which the triggering event occurs. A triggering event occurs when: (i) the corporation ceases to be an S corporation (determined as of the first day of the first tax year that the corporation is not an S corporation); (ii) the S corporation liquidates or sells substantially all its assets (including in a Title 11 or similar case), the S corporation ceases doing business, the S corporation ceases to exist, or any similar circumstance; or (iii) a taxpayer transfers any share of stock in the S corporation (including by reason of death, or otherwise). In the case of a transfer of less than all of the taxpayer's shares of stock in the S corporation, the transfer is only a triggering event to the extent of the portion of the taxpayer's net tax liability allocable to the transferred stock. Even if a triggering event occurs, the Section 965(i) net tax liability will not be accelerated if the S corporation shareholder transfers the S corporation stock (including by reason of death or otherwise), and the shareholder (an "eligible Section 965(i) transferor") and an "eligible section 965(i) transferee" (a United States person that is not a domestic pass-through entity) enter into a transfer agreement with the Commissioner within 30 days of the triggering event. The transferee must assume all of the outstanding obligations and responsibilities with respect to the deferred Section 965(i) amount. The terms of the agreement must contain the information described in Prop. Reg. Section 1.965-7(c)(3)(iv)(B)(4). Generally, an S corporation shareholder may make an 8-year installment election after a triggering event has occurred. However, the Proposed Regulations provide a special rule that requires an S corporation shareholder to obtain consent of the Commissioner before making an 8-year installment election in the event of a triggering event that is a liquidation, sale, exchange, or other disposition of substantially all of the assets of the S corporation (including in a Title 11 or similar case), a cessation of business by the S corporation, or the S corporation ceasing to exist. Key takeaways — The S corporation deferral election is available only to shareholders of S corporations where the S corporation is a US shareholder with respect to a DFIC. — Taxpayers making an S corporation deferral election must report their Section 965(i) net tax liability annually. — In the case of a triggering event that is a transfer of the S corporation stock to an "eligible transferee," the transferor and transferee may continue to defer the Section 965(i) net tax liability by entering into an agreement with the Commissioner. This agreement needs to be filed with the Commissioner within 30 days of the triggering event. — A domestic pass-through entity is not an "eligible transferee" for purposes of entering into an agreement to continue to defer the Section 965(i) net tax liability. This raises significant questions as to whether certain trusts that are qualified to own S corporation stock, such as a QSST that passes out all of its income to its beneficiary each year, and estates are treated as "eligible transferees." Prop. Reg. Section 1.962-1 and -2: Section 962 elections Section 962 provides that an individual who is a US shareholder of a foreign corporation may elect to be taxed at corporate rates under Section 11 for subpart F income, including Section 965(a) inclusions. If an election is made under Section 962, the amounts included in the individual's gross income under Section 951(a) are treated as if they were received by a domestic corporation, allowing the individual to claim foreign tax credits for deemed-paid foreign taxes arising from the subpart F inclusion. However, distributions received by the electing US shareholder from the foreign corporation are taxable to the extent the distribution exceeds the amount of tax paid by the US shareholder with respect to the subpart F inclusion. A Section 962 election is an annual election and does not affect the tax imposed under other chapters, including Chapter 2A (i.e., the NIIT). The Proposed Regulations clarify who can make the Section 962 election for purposes of the Section 965 net tax liability, and explicitly allow the Section 965(c) deduction to be taken to offset the Section 965(a) inclusion. Prop. Reg. Section 1.962-2(a) clarifies that an individual domestic pass-through owner that is a US shareholder with respect to a DFIC may make an election under Section 962 with respect to the individual's share of the Section 965(a) inclusion amount of a domestic pass-through entity with respect to the DFIC. However, an individual who is not a US shareholder of a DFIC is not permitted to make an election under Section 962 with respect to the individual's share of a Section 965(a) inclusion amount of a domestic pass-through entity with respect to the DFIC. Thus, only individuals and trusts with US shareholder status (i.e., those who own 10% or more of the vote (or value for tax years beginning after December 31, 2017) of a CFC) are eligible to make the Section 962 election. Generally, under Reg. Section 1.962-1(b)(1)(i), a US shareholder may not reduce the amount included in gross income under Section 951(a) for any deductions for purposes of computing the amount of tax that would be imposed under Section 11. Notwithstanding that, the IRS and the Treasury Department have determined that, in the case of a taxpayer making an election under Section 962 with respect to a Section 965(a) inclusion, the Section 965(c) deduction (which is generally available to US shareholders of DFICs, including individuals) is allowed with respect to the tax imposed under Section 11 rather than under Section 1. Thus, under Prop. Reg. Section 1.962-1(b)(1)(i)(B), "taxable income" as used in Section 11 is reduced by a taxpayer's Section 965(c) deduction with respect to a Section 965(a) inclusion to which the Section 962 election applies. However, the Proposed Regulations clarify that, subject to future guidance, "taxable income" as used in Section 11 is not reduced by other amounts, including any other deductions.5 The Proposed Regulations further clarify that a Section 965(c) deduction taken into account in determining "taxable income" as used in Section 11 cannot then be deducted again at the individual level. The Proposed Regulations provide several clarifications to the effect of the transition tax on basis. However, rules relating to basis adjustments in the case of a Section 962 election are reserved. The Treasury Department requests comments as to the appropriate amount of a basis adjustment for a DFIC with respect to which a Section 962 election is effective. Key takeaways — The Section 965(c) deduction is allowed for taxpayers who make a Section 962 election with respect to their Section 965 net tax liability. — Individuals who are both domestic pass-through owners and US shareholders are eligible to make the Section 962 election with respect to their Section 965 net tax liability. — Absent additional guidance, the Section 250 deduction used to offset Section 951A GILTI inclusions may not be available under Section 962. Section 1411 (NIIT): Proposed regulations Section 1411, commonly referred to as the net investment income tax or NIIT, generally imposes a tax of 3.8% on the net investment income of high-income individuals and of certain trusts and estates. In general, investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer. Generally, deductions allowed for regular income tax purposes are allowed in computing "net investment income," but only to the extent they are properly allocable to the types of income just listed. The Proposed Regulations make clear that the Section 965(c) deduction is not a "properly allocable" deduction for purposes of Section 1411. As a result, the Section 965(c) deduction is not deductible for purposes of NIIT. The Proposed Regulations specify that a foreign corporation that is an SFC because it has a 10% domestic corporate shareholder will be treated as a CFC for purposes of Reg. Section 1.1411-10. Under Reg. Section 1.1411-10, the Section 965(a) inclusion will be subject to NIIT when it is actually distributed. However, if a taxpayer makes an election under Reg. Section 1.1411-10(g), subpart F income, including the Section 965(a) inclusion, will be included in NIIT in the same year such amount is included in income for regular tax purposes. The Proposed Regulations also make clear that the 8-year installment election and S corporation deferral election are not applicable to the NIIT. If a taxpayer does not make an election under Reg. Section 1.1411-10(g), the Section 965(a) inclusion will not be subject to NIIT until the taxpayer receives a distribution from the SFC. However, if a taxpayer makes an election under Reg. Section 1.1411-10(g), the taxpayer will be subject to NIIT on the entire Section 965(a) inclusion amount in the current year, regardless of whether the taxpayer has made a Section 965(h) or 965(i) election. Key takeaways — If the taxpayer does not make an election under Reg. Section 1.1411-10(g), the Section 965(a) inclusion is subject to NIIT when it is distributed. — If the taxpayer makes an election under Reg. Section 1.1411-10(g), the Section 965(a) inclusion is subject to NIIT in the current year. — Under the Proposed Regulations, the Section 965(c) deduction is not deductible for purposes of NIIT. We expect that the IRS will receive comments on whether this position is correct in light of the rules under Section 1411. ———————————————
——————————————— 1 All "section" references are to the Internal Revenue Code of 1986, and the regulations promulgated thereunder. 2 See also Revenue Procedure 2018-17, 2018-9 I.R.B. 384. 3 Section 958(a) provides that stock owned means stock owned directly, and stock owned indirectly through foreign corporations, foreign partnerships, foreign trusts, or foreign estates. 4 Prop. Reg. Section 1.965-1(f)(28) defines "pass-through entity" as "a partnership, S corporation, or any other person (whether domestic or foreign) other than a corporation to the extent that the income or deductions of the person are included in the income of one or more direct or indirect owners or beneficiaries of the person. For example, if a domestic trust is subject to federal income tax on a portion of its [S]ection 965(a) inclusion amount and its domestic pass-through owners are subject to tax on the remaining portion, the domestic trust is treated as a domestic pass-through entity with respect to such remaining portion." 5 Presumably, the reference in this sentence to "any other deductions" prohibits a taxpayer who makes a Section 962 election from claiming the Section 250 deduction to offset Section 951A global intangible low tax income (GILTI) inclusions. Absent additional guidance, individuals making a Section 962 election may not be able to claim the 50% deduction with respect to Section 951A GILTI inclusions. | |||||||||||||||||
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