August 10, 2018 Proposed Section 965 regulations provide guidance to private foundations regarding income to be included in net investment income The IRS has released proposed regulations under Section 965 that, among other things, clarify the treatment of income subject to the transition tax by private foundations for purposes of calculating the excise tax on net investment income under Section 4940. This Tax Alert focuses on the implications of the proposed regulations to private foundations. For a comprehensive discussion of the proposed regulations, see Tax Alert 2018-1571. Background Section 965 transition tax Section 965, enacted by the Tax Cuts and Jobs Act, imposes a one-time transition tax which requires a US shareholder (as defined in Section 951(b)) to include in income the accumulated deferred foreign income of each controlled foreign corporation (CFC) and each of certain other foreign corporations with a 10% domestic corporate shareholder, collectively referred to as "specified foreign corporations" (each an SFC). Section 965(a) generally provides that the subpart F income of an SFC in its last 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. Under Section 965(c), a US shareholder is entitled to a deduction with respect to its Section 965(a) inclusion amount that is intended to have the effect of reducing 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. 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. For more detail on the Section 965 transition tax, see Tax Alert 2018-1571. Section 4940 excise tax Section 4940 imposes an excise tax on net investment income of private foundations. Net investment income is determined using rules set forth in Section 4940(c), which defines "net investment income" as the amount by which the sum of the gross investment income and the capital gain net income exceeds allowable deductions. Under Section 4940(c)(2), gross investment income does not include income to the extent it is included in computing unrelated business income tax under Section 511. Section 4940(c)(3) allows as a deduction all the ordinary and necessary expenses paid or incurred for the production or collection of gross investment income or for the management, conservation or maintenance of property held for the production of such income. Proposed regulations with respect to Section 4940 For purposes of determining the excise tax under Section 4940, the preamble to the proposed regulations states that "an inclusion under [S]ection 951(a)(1), including a [S]ection 965(a) inclusion, generally is included in the calculation of gross investment income of a private foundation." The proposed regulations also specifically state that, for purposes of Section 4940(c)(3), a Section 965(c) deduction is not treated as an ordinary and necessary expense paid or incurred for the production or collection of gross investment income. Comments to the Treasury Department and the IRS requested that the tax imposed due to the inclusions of Section 965(a) be payable in installments under Section 965(h). However, the Treasury Department and the IRS have determined that Section 965(h) applies only with respect to income taxes or tax imposed under subchapter A of chapter 1 of subtitle A of the Code. Accordingly, elections may not be made to pay by installments the tax imposed under other subchapters or chapters (such as, for example, the taxes imposed under Sections 1411 and 4940). Implications For the first time, private foundations have clear guidance on the general inclusion of subpart F income in Section 4940 gross investment income. The Section 965 proposed regulations explicitly indicate that subpart F income, as well as the Section 965 inclusion, are generally included in the calculation of net investment income under Section 4940. No specific guidance heretofore has been provided regarding Section 4940 and subpart F income for private foundations. Additionally, unlike taxpayers subject to subchapter A income taxes, the proposed regulations do not allow private foundations a Section 965(c) deduction for purposes of computing the Section 965 inclusion in Section 4940 net investment income. Private foundations invested directly or indirectly in an SFC may include only Section 965(a) income and not Section 965(c) deductions for purposes of determining net investment income for Section 4940. Any incremental Section 4940 net investment income excise tax liability incurred by a private foundation as a result of the Section 965 inclusion must be paid by its normal estimated tax deadlines in accordance with the private foundation estimated tax rules applicable to net investment income. Private Foundations are not afforded any special rules or timeline for payment of the additional excise taxes related to Section 965. Please contact your Ernst & Young LLP tax professional with any questions. ——————————————— -- For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg. ———————————————
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