Treasury Issues Final Regulations Regarding the Transition Tax Under Section 965 and Related Provisions

January 2019

Summary

On January 15, 2019, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury) issued final regulations implementing Section 965 (the Final Regulations). The Final Regulations finalize the proposed regulations under Section 965 (the Proposed Regulations) with certain modifications. See our August 2018 Tax Alert for a discussion of the Proposed Regulations. The Final Regulations affect U.S. persons with direct or indirect ownership interests in certain foreign corporations.
 

Details

In the preamble to the Final Regulations (the Preamble), Treasury discusses the numerous comments received in response to the Proposed Regulations. This tax alert summarizes some of the key modifications and clarifications included as part of the Final Regulations. See the Preamble for a discussion of the comments and recommendations not adopted by Treasury as part of the Final Regulations as well as other modifications and clarifications included in the Final Regulations that are not discussed in this tax alert.

1. Certain Modifications and Clarifications made to Proposed §1.965-1 – Overview, General Rules and Definitions
Proposed §1.965-1 provides general rules and definitions under Section 965, including general rules concerning Section 965(a) inclusion amounts, general rules concerning Section 965(c) deduction amounts, and rules concerning the treatment of certain specified foreign corporations (as defined in Section 965(e)) as controlled foreign corporations (CFCs as defined in Section 957) and certain controlled domestic partnerships as foreign partnerships.

The Final Regulations revise the definition of “pro rata share” and “Section 958(a) U.S. shareholder inclusion year” to address situations where a specified foreign corporation, whether it is or is not a CFC, ceases to be a specified foreign corporation during its inclusion year. In the Preamble, Treasury concludes that it would not be appropriate to prorate a Section 965(a) earnings amount based on the portion of the inclusion year that the deferred foreign income corporation (DFIC as defined in Section 965(d)) is a specified foreign corporation, as the reference in Proposed §1.965-1(f)(30)(i) to Section 965(a)(2)(A) might suggest, given that the limitation of post-1986 earnings and profits (E&P) to E&P accumulated in periods in which the DFIC was a specified foreign corporation would already prevent E&P accrued after the DFIC ceased to be a specified foreign corporation from being taken into account.[1] The definition of pro rata share continues to preclude reduction by distributions to other owners under Section 951(a)(2)(B) in order to be consistent with Section 965(d)(3)(B) and prevent double non-taxation in the case of certain 2018 dispositions of specified foreign corporations.[2]

The Final Regulations extend the special rule in Proposed §1.965-1(f)(45)(ii)[3] concerning downward attribution of stock to trusts.[4] In addition, the Final Regulations increase the threshold for application of this special attribution rule for partnerships from 10 percent to 10 percent, and similarly use a 10-percent threshold for the newly-added special attribution rule for trusts.

Other modifications and clarifications made to Proposed §1.965-1 by the Final Regulations include, among other items, (1) modifying the rules regarding a controlled domestic partnership treated as a foreign partnership under the rule described in Proposed §1.965-1(e),[5] (2) providing additional, narrowly tailored cash position exceptions for specified foreign corporations,[6] (3) clarifying the rules regarding the treatment of cash-equivalent asset hedging transactions,[7] and (4) modifying the rules for purposes of determining a U.S. shareholder’s pro rata share of a specified E&P deficit of an E&P deficit foreign corporation.[8]

2. Certain Modifications and Clarifications made to Proposed §1.965-2 – Adjustments to E&P and Basis
Proposed §1.965-2 contains rules relating to adjustments to E&P and basis to determine and account for the application of Section 965(a) and (b) and Proposed §1.965-1(b), and a rule that limits the amount of gain recognized in connection with the application of Section 961(b)(2).

The Final Regulations provide that Section 1248 amounts are determined before, and may reduce, a buyer’s Section 965(a) inclusion amount with respect to a DFIC. The application of the ordering rule in connection with a sale to which Section 1248 applies is illustrated in a new example in §1.965-2(j)(6).

Also, the Final Regulations clarify that Section 965(b) previously taxed earnings and profits are treated as E&P attributable to an amount previously included in the income of a person under Section 951 for purposes of Section 1248(d)(1).[9]

The Proposed Regulations allow a Section 958(a) U.S. shareholder to elect to make certain basis adjustments (specified basis adjustments) with respect to each DFIC and each E&P deficit foreign corporation.[10] Reg. §1.965-2(f)(2)(ii)(B)(2) provides that downward basis adjustments to the stock of, or applicable property with respect to, an E&P deficit foreign corporation may be limited to the available basis with the result that gain is not recognized (the to-the-extent rule). If the to-the-extent rule limits downward basis adjustments, the corresponding upward basis adjustments are correspondingly limited.[11] However, the Section 958(a) U.S. shareholder can (subject to certain limitations) designate the stock of, or applicable property with respect to, a DFIC with respect to which the upward adjustments are made.[12] A taxpayer may also choose to make the full amounts of the adjustments that would have been required under the Proposed Regulations and recognize gain under §1.965-2(h)(3) as necessary.[13]

Other modifications and clarifications made to Proposed §1.965-2 by the Final Regulations include, among other items, (1) expanding the application of the ordering rules in Proposed §1.965-2(b),[14] (2) providing guidance regarding the interaction of the ordering rule, foreign tax credit rules and the disregard rules,[15] (3) clarifying certain rules regarding adjustments to the E&P of DFICs,[16] (4) providing additional guidance with respect to the basis election in §1.965-2(f), (5) providing rules for basis adjustments with respect to a Section 958(a) U.S. shareholder that made a Section 962 election,[17] and (6) providing additional guidance regarding the gain reduction rule and translation rates.

3. Certain Modifications and Clarifications made to Proposed §1.965-3 – Section 965(c) Deductions
Proposed §1.965-3 provides rules regarding the determination of Section 965(c) deductions and Section 965(c) deduction amounts.

The Final Regulations clarify that for purposes of Section 965(l)(1),[18] an expatriated entity includes not only entities but certain persons (which could be individuals) related to the entity at issue.[19]

The Final Regulations clarify that a Section 965(c) deduction is a deduction taken into account under Section 62(a) in determining an individual’s adjusted gross income.[20]

Other modifications and clarifications made to Proposed §1.965-3 by the Final Regulations include, among other items, (1) clarifying rules relating to cash measurement dates,[21] and (2) providing additional guidance with respect to the rule for cash positions of certain non-corporate entities in Section 965(c)(3)(E).[22]

4. Certain Modifications and Clarifications made to Proposed §1.965-4 – Disregard Certain Transactions
Proposed §1.965-4 sets forth rules that disregard certain transactions for purposes of applying Section 965. Specifically, Proposed §1.965-4 provides rules that disregard (i) transactions undertaken with a principal purpose of changing a Section 965 element of a U.S. shareholder, (ii) certain changes in method of accounting and entity classification elections, and (iii) certain transactions occurring between E&P measurement dates.

Reg. §1.965-4(e)(4) provides that in the case of a liquidation of a specified foreign corporation that is disregarded for purposes of determining the Section 965 elements of a U.S. shareholder pursuant to §1.965-4(b) or (c)(2), for purposes of determining the amounts of the Section 965 elements of the U.S. shareholder, the date of the liquidation generally is treated as the last day of the taxable year of the specified foreign corporation. Special rules apply with respect to liquidations resulting from entity classification elections, including a rule that may defer the date of liquidation for this purpose to the date on which the entity classification election is filed.

The Final Regulations provide an exception from the anti-abuse rules for certain incorporation transactions. Under the exception, the anti-abuse rules do not apply to disregard a transfer of stock of a specified foreign corporation by a U.S. shareholder to a domestic corporation (for this purpose, including an S corporation), provided that the Section 965(a) inclusion amount with respect to the transferred stock of the specified foreign corporation is not reduced and that the aggregate foreign cash position of both the transferor and the transferee is determined as if each had held the transferred stock of the specified foreign corporation owned by the other on each of the cash measurement dates.[23]

The Final Regulations provide that in the case of a cash reduction transaction that is a distribution by a specified foreign corporation of a U.S. shareholder, there is not considered to be a plan or intention for the distributee to transfer cash, accounts receivable, or cash-equivalent assets to any specified foreign corporation of the U.S. shareholder if the transfer is made by the distributee pursuant to a legal obligation entered into before November 2, 2017.[24] If the taxpayer relies on this rule in determining that a cash reduction transaction is not a specified distribution, it must attach a statement to its return indicating that position.[25]

In the Preamble, Treasury states that it did not adopt comments suggesting that the rule in Proposed §1.965-4(c)(1), which applies to changes in methods of accounting, not apply to changes from impermissible methods of accounting to permissible methods of accounting, and that the rule be conditioned on a principal purpose of changing a Section 965 element.

Other modifications and clarifications made to Proposed §1.965-4 by the Final Regulations include, among other items, (1) modifying the rule in Proposed §1.965-4(c)(1) to apply only if there is a reduction in a Section 965(a) inclusion amount or an aggregate foreign cash position, or an increase in Section 960 deemed paid taxes other than by reason of an increase in a Section 965(a) inclusion amount,[26] and (2) eliminating the requirement that the specified foreign corporations between which a payment is made have different tentative measurement dates in order for the payment to be a specified payment disregarded under the rule in proposed §1.965-4(f)(1) and provide that a Section 958(a) U.S. shareholder may choose not to apply the rule in §1.965-4(f)(1), provided that it and all related Section 958(a) U.S. shareholders do so with respect to all of their specified foreign corporations.[27]

5. Certain Modifications and Clarifications made to Proposed §1.965-5 and §1.965-6 – Foreign Tax Credits
Proposed §1.965-5 and §1.965-6 provide rules with respect to foreign tax credits. The Proposed Regulations include, in addition to the foreign tax credit specific rules of Section 965, rules coordinating the provisions of Section 965 with the foreign tax credit provisions as in effect before their repeal or amendment by the Tax Cuts and Jobs Act.

The Final Regulations provide that if there is no aggregate Section 965(a) inclusion amount, the applicable percentage of foreign income taxes attributable to a distribution of Section 965(b) previously taxed earnings and profits that are not creditable or deductible is 55.7 percent (that is, the applicable percentage that would apply if the Section 965(b) previously taxed earnings and profits had been included in income and were an amount to which Section 965(c)(1)(B) applied).[28]

The Final Regulations also provide that to the extent the hovering deficit would have been absorbed by E&P accrued during the taxable year but for a Section 965(a) inclusion, taxes that relate to the hovering deficit are taken into account for purposes of determining post-1986 foreign income taxes. Therefore, §1.965-6(d) provides that in the last taxable year that begins before January 1, 2018, of a DFIC that is also a foreign surviving corporation, for purposes of determining the related taxes that are included in post-1986 foreign income taxes, the post-transaction earnings that can be offset by a hovering deficit include any current year earnings which were included under Section 965 by a Section 958(a) U.S. shareholder; and the hovering deficit offset is treated as occurring as of the last day of the DFIC’s inclusion year.

Other modifications and clarifications made to Proposed §1.965-5 and §1.965-6 by the Final Regulations include, among other items, clarifying how the applicable percentage applies with respect to domestic pass-through owners and with respect to distributions of previously taxed E&P.[29] 

6. Certain Modifications and Clarifications made to Proposed §1.965-7 – Elections and Payment Rules
Proposed §1.965-7 provides rules regarding the timing and manner of certain elections that may be available to taxpayers under Section 965, and payments to be made pursuant to those elections.

In the Preamble, Treasury states that it has determined that any disposition of substantially all of the assets of the person making the Section 965(h) election, the S corporation, or the REIT, including in a tax-free reorganization or an exchange described in Section 351 or 721, poses a risk to the IRS’s ability to collect the full amount of the Section 965(h) net tax liability, Section 965(i) net tax liability, or total net tax liability under Section 965, as the case may be. The Preamble further provides that Treasury has determined that it is essential for tax administration purposes for the IRS to be apprised of these dispositions. Treasury believes that providing an exclusion to the general rule that an exchange or other disposition of substantially all of the assets of the person making the Section 965(h) election, the S corporation with respect to which a Section 965(i) election is in effect, or the REIT with a Section 965(m) election in effect for nonrecognition transactions could hamper the IRS’s ability to collect the outstanding tax liabilities and could enable certain taxpayers to inappropriately dilute their interests in their assets or change their businesses in a way that is inconsistent with the purposes behind the elections and related triggering and acceleration events. The Final Regulations also do not include a special exception for reorganizations under Section 368(a)(1)(F) because Treasury believes requiring a transfer agreement, if applicable, in those situations is necessary for tax administration purposes.

Section 965(h) elections and Section 965(i) elections allow the deferral of payment of amounts based on a taxpayer’s total net tax liability under Section 965.[30] Total net tax liability is calculated on the basis of a taxpayer’s net income tax “with” and “without” the application of Section 965, which is intended to isolate the portion of a taxpayer’s net income tax attributable to Section 965. The Final Regulations disregard inclusions under Sections 951(a)(1)(B) and 956 for purposes of the “without” computation in order to ensure that the total net tax liability under Section 965 reflects an accurate measure of a taxpayer’s tax due to Section 965.[31]  The Final Regulations also clarify that the dividends disregarded for purposes of the “without” computation are limited to those paid by a DFIC during the DFIC’s inclusion year.[32]

Other modifications and clarifications made to Proposed §1.965-7 by the Final Regulations include, among other items, modifications and clarifications to (1) election statements, (2) acceleration events and triggering events, (3) transfer agreements,[33] (4) the 965(h), (i), (m) and (n) elections, and (5) the election to use the alternative method of calculating post-1986 earnings and profits.

7. Certain Modifications and Clarifications made to Proposed §1.965-8 – Affiliated Groups (Including Consolidated Groups)
Proposed §1.965-8 sets forth rules governing the application of Section 965 and the Section 965 regulations to members of an affiliated group (as defined in Section 1504(a)), including members of a consolidated group (as defined in §1.1502-1(h)).

The Final Regulations provide that the consolidated group aggregate foreign cash position is determined as if all members of a consolidated group that are Section 958(a) U.S. shareholders of a specified foreign corporation were a single Section 958(a) U.S. shareholder.[34]

8. Applicability Dates
The Final Regulations retain the applicability dates that were in the Proposed Regulations and, consistent with the applicability date of Section 965, generally apply beginning the last taxable year of a foreign corporation that begins before January 1, 2018, and with respect to a U.S. person, beginning the taxable year in which or with which such taxable year of the foreign corporation ends.[35] For details regarding the applicability dates, see the Final Regulations .
 

BDO Insights

 The Final Regulations provide additional clarity for taxpayers subject to Section 965. BDO can assist clients with understanding and applying the Final Regulations.
 

CONTACT:
 
Joe Calianno
Partner and International Tax Technical Practice Leader
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  Monika Loving
Partner and International Tax Practice Leader
 

 
Brandon Boyle
Principal
  Annie Lee
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Partner
  Robert Pedersen
Partner

 
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Principal
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Sean Dokko
Senior Manager
National Tax Office
 
[1] See §1.965-1(f)(30) and (f)(34) for additional details.
[2] Id.; see §1.965-2(j)(6).
[3] This rule provides that solely for purposes of determining whether a foreign corporation is a specified foreign corporation within the meaning of Section 965(e)(1)(B), stock owned, directly or indirectly, by or for a partner (tested partner) will not be considered as being owned by a partnership under Sections 958(b) and 318(a)(3)(A) if the tested partner owns less than five percent of the interests in the partnership’s capital and profits. Similar rules apply with respect to S corporations. See Sections 318(a)(5)(E) and 1373(a).
[4] See §1.965-1(f)(45)(ii)(A)(2).
[5] See §1.965-1(e). The Final Regulations also provide that a controlled domestic partnership treated as a foreign partnership is treated as a foreign pass-through entity for purposes of the specified basis adjustment rules in §1.965-2(f). See §1.965-2(i)(2).
[6] See §1.965-1(f)(13)(i)(A) and (ii) and §1.965-1(f)(18)(iii) and (v).
[7] See §1.965-1(f)(14)(ii).
[8] See §1.965-1(f)(30)(ii)(A) and §1.965-1(f)(30)(ii)(B).
[9] See §1.965-2(d)(1).
[10] Proposed §1.965-2(f)(2).
[11] See §1.965-2(f)(2)(ii)(A)(2)(ii).
[12] Id.
[13] See §1.965-2(f)(2)(ii)(A)(1) and (f)(2)(ii)(B)(1).
[14] See §1.965-2(b).
[15] See §1.965-2(b), §1.965-6(b), §1.965-2(b)(1) and (4) and §1.965-2(j)(1) and (4).
[16] See §1.965-2(d)(1).
[17] See §1.965-2(e)(2) and (h)(1).
[18] Under Section 965(l)(1) and Proposed §1.965-3(d)(1), if a person is allowed a Section 965(c) deduction and becomes an expatriated entity, in certain circumstances, the person must pay tax equal to 35 percent of the person’s Section 965(c) deductions. 
[19] See §1.965-3(d)(2).
[20] See §1.965-3(f)(1).
[21] See §1.965-3(b)(2). Corresponding clarifications are made for consistency in §1.965-3(b)(1).
[22] See the example in §1.965-3(b)(4)(v). Section 965(c)(3)(E) provides that an entity (other than a corporation) is treated as a specified foreign corporation of a U.S. shareholder for purposes of determining the U.S. shareholder’s aggregate foreign cash position if any interest in the entity is held by a specified foreign corporation of the U.S. shareholder (determined after application of the rule in this sentence) and the entity, if it were a foreign corporation, would be a specified foreign corporation of the U.S. shareholder.
[23] See §1.965-4(e)(3).
[24] See §1.965-4(b)(2)(iii)(B).
[25] Id.
[26] See §1.965-4(c)(1)(i).
[27] See §1.965-4(f)(1), (2), and (3).
[28] See §1.965-5(d)(2).
[29] See §1.965-5(d)(3) and (4).
[30] See §1.965-7(b)(1), (c)(1), (g)(4), and (g)(6).
[31] See §1.965-7(g)(10)(i)(B)(2).
[32] See id.
[33] The transition rules in §1.965-7(b)(3)(iii)(B)(2)(ii) and §1.965-7(c)(3)(iv)(B)(2)(ii) have been updated to provide that if a triggering event or acceleration event occurs on or before the date the Final Regulations are published in the Federal Register, the transfer agreement must be filed by 30 days after the Final Regulations are published in the Federal Register, in order to be considered timely filed. See also §1.965-7(c)(3)(v)(D)(2)(ii) (similarly extending the deadline for filing agreements to make a section 965(h) election after a triggering event).
[34] See §1.965-8(e)(1), (e)(3), and (f)(4).
[35] See Section 7805(b)(2).