As of January 1, 2018, the 2017 Tax Cuts & Jobs Act (TCJA) changes the taxation regime for U.S. multinational corporations, especially U.S.-owned controlled foreign corporations (CFC). The international provisions in TCJA introduce a new territorial system for the taxation of foreign company income. Before these new tax provisions take effect, the new law imposes a mandatory one-time tax (the “Transition Tax”) on certain foreign company earnings traditionally not subject to U.S. federal income tax until distributed as a dividend to U.S. shareholders.
Due to the complexity of the topic, which also is unchartered territory, we will discuss the Transition Tax in a four-part series: Part I explains which taxpayers are subject to the Transition Tax and the due dates for different taxpayers. Part II will discuss the complexity in determining the tax rates for the Transition Tax. Part III will explain two key components in determining taxable income subject to Transition Tax: 1) accumulated post-1986 deferred foreign income (DFI), and 2) aggregated foreign cash position. Part IV will provide examples illustrating the calculations of the Transition Tax.
TCJA amends Internal Revenue Code (IRC) Section 965, which uses the mechanics under subpart F provisions to impose a one-time mandatory tax on the undistributed, non-previously taxed, post-1986 foreign earnings and profits (E&P) of certain specified foreign corporations (SFCs) with DFI.
Are you subject to the Transition Tax?
Generally, you are subject to the Transition Tax if you are a U.S. shareholder of a deferred foreign income company (DFIC). A DFIC is a SFC with positive accumulated, untaxed post-1986 E&P determined as of November 2, 2017, or December 31, 2017. A SFC is any CFC and any foreign corporation with one or more domestic corporations as a U.S. shareholder.
A U.S. shareholder is a U.S. person who owns directly, indirectly, or constructively 10 percent or more of the total combined voting power of all classes of stock of a foreign corporation entitled to vote. A U.S. person is a U.S. citizen (excluding certain citizens or residents of U.S. possessions) or resident, a domestic entity including partnership, corporation, or estate trust. In addition, for the determination of residency for CFC purposes, the resident status under an income tax treaty may not apply. Constructive ownership generally means a U.S. person is considered to own shares owned by certain related family members (e.g., spouse, children, parents/grandparents, etc.) and certain related business entities (e.g., corporations, partnerships, trusts, estates, etc.).
Stock attribution rules for determining constructive ownership, whether a foreign corporation is a CFC and whether a U.S. person is treated as a U.S. shareholder, can be complex. Under pre-TJCA law, a CFC is any foreign corporation in which more than 50 percent of the total combined voting power of all classes of stock entitled to vote is owned directly, indirectly, or constructively by U.S. shareholders on any day during the taxable year of such foreign corporation, or more than 50% of the total value of the stock is owned directly, indirectly or constructively by U.S. shareholders on any day during the taxable year of the corporation.
TJCA makes changes to the definition of CFC here by changing the stock attribution rules for determining whether a foreign corporation is a CFC. The changes apply to the last taxable year of a foreign corporation beginning before Jan. 1, 2018, and each subsequent taxable year of such foreign corporation. Some foreign corporations not considered CFCs before this amendment may be treated as CFCs for certain purposes including the Transition Tax effective in 2017.
When is the Transition Tax due?
DFI is included in the income of a U.S. shareholder on the last day of the last taxable year of the SFC beginning before January 1, 2018. Thus,
- If the SFC’s taxable year ends on December 31, 2017, DFI is included in a U.S. shareholder’s 2017 U.S. tax return. Therefore, for individual taxpayers and calendar-year domestic corporate taxpayers, the Transition Tax is generally due on April 17, 2018, the due date for 2017 tax returns, even though the due date of the taxpayer’s tax return may be extended to a later date.
- If the SFC’s taxable year ends before December 31, 2017, e.g., November 30, 2017, its next taxable year would have begun on December 1, 2017, which is before January 1, 2018. Here, DFI is included in the U.S. shareholder’s 2018 U.S. tax return, and the Transition Tax is generally due on April 15, 2019 for calendar year taxpayers.
- Section 965 states a U.S. shareholder may elect to pay the Transition Tax over 8 years in 8 installments of the following amounts: 8% of net tax liability in each of years 1-5, 15% in year 6, 20% in year 7, and 25% in year 8.
- There are special rules for S corporation shareholders. A shareholder of an S corporation with DFI may elect to defer payment of the Transition Tax indefinitely until the earlier of the following triggering events: (i) the S corporation ceases to be an S corporation; (ii) a liquidation or sale of substantially all the assets of such S corporation (including in a title 11 or similar case), a cessation of business by such S corporation, such S corporation ceases to exist, or any similar circumstance; and (iii) a transfer of any share of stock in such S corporation by the taxpayer (including from death, or otherwise, subject to certain exceptions). With a transfer of less than the taxpayer's shares of stock in the S corporation, such transfer only triggers the taxpayer's Transition Tax liability regarding such S corporation as is properly allocable to such stock. Section 965 imposes reporting requirements for an S corporation with DFI and annual reporting requirements for any U.S. shareholder of an S corporation who elects to defer the Transition Tax liabilities and a 5% penalty for failure to report. In addition, if any shareholder of an S corporation elects to defer the Transition Tax, such S corporation is jointly and severally liable for such payment and any penalty and additional taxes related to the Transition Tax.
- There are also special rules for U.S. shareholders that are Real Estate Investment Trusts (REITs). DFI does not count as gross income solely for the REIT income tests. In addition, to compute its REIT taxable income, subject to acceleration of inclusion upon certain triggering events, a REIT may elect to include such income in the calculation of its REIT taxable income ratably over the 8 years starting with the taxable year in which the income would otherwise be required to be included in gross income, in the same percentages in which the Transition Tax must be paid with an installment payment election (i.e., 8% in years 1-5, 15% in year 6, 20% in year 7, and 25% in year 8).
The rules for calculating the Transition Tax are complicated, especially for taxpayers with complex corporate structures. Stay tuned for updates. As the new tax laws become effective, The Tax Warriors® will be available to assist you. Contact us at Drucker & Scaccetti with questions.