As of January 1, 2018, the 2017 Tax Cuts & Jobs Act (TCJA) changes the taxation regime for U.S. multinational corporations. 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.
The one-time transition tax is on post-1986, untaxed foreign earnings of specific foreign corporations owned by U.S. shareholders. The TCJA treats these foreign earnings as repatriated and places a 15.5 percent tax on cash or cash equivalents, and an 8 percent tax on the remaining earnings. Generally, the transition tax can be paid in installments over an eight-year period when a taxpayer files a timely election under section 965(h).
We will discuss the one time transition tax in three parts: 1) Who is subject to the transition tax; 2) the due dates for different taxpayers, and; 3) potential Section 962 election.
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). DFICs are specified foreign corporations (SFC) with positive earnings and profits that haven’t been previously subject to US tax. This includes all foreign corporations where a US corporate shareholder has a 10% or greater interest. A few points to expand upon:
- Related party rules must be considered to determine if the 10% ownership threshold is met.
- An individual is considered to own all the foreign stock owned by his or her spouse/children, and the family attribution rules extend to all grandparents and any number of great-grandparents or grand-children and their spouses.
- Partners own their share of any foreign corporations owned by their partnerships, and corporations own their share of any foreign subsidiaries no matter how far down the chain.
- Beneficiaries who have their share of foreign corporations inside a trust are included. The attribution rules were expanded as well, so a fresh ownership analysis might be necessary in many situations.
When is the Transition Tax due?
Based on new Section 965, the only due date mentioned for the transition tax is in the context of the 8-year installment election. Section 965 caveats that “the first installment shall be paid on the due date (determined without regard to any extension of time for filing the return) for the return of tax for the taxable year.” The natural reading of the statute seems to be that the first installment should be due on April 15 even for those living abroad, because June 15 is essentially an extension of the original due date.
What is Section 962 election?
Section 962 allows an individual U.S. shareholder (including a trust or estate) to elect to be taxed at corporate income tax rates on certain Subpart F income under Sec. 951(a). The “repatriation tax” included in TCJA may cause individual partners and shareholders of flow-through entities (as well as direct individual shareholders) with controlled foreign corporations (CFCs) that have foreign subsidiaries with earnings and profits (E&P) subject to the repatriation tax to obtain a deferred tax rate benefit by making this election.
In making a Sec. 962 election, the individual is effectively taxed at the U.S. corporate tax rate, which may be higher than the individual’s marginal tax rate, but the individual is entitled to a credit for the indirect foreign taxes paid by the foreign corporation (by virtue of the mechanics of the Sec. 78 gross-up calculation that applies to corporate shareholders in receipt of foreign dividends from a CFC). This provision increases the income taxable to the shareholder by a pro rata share of the foreign corporate taxes paid by the CFC, but because those taxes are then available for credit against the individual taxpayer’s U.S. tax liability, the net tax result can actually be, initially, economically advantageous.
In summary, a Sec. 962 election allows the possibility of deferring tax until a later actual repatriation of corresponding Sec. 962 E&P. However, there is a very real possibility that the value of the deferral may be offset by a higher tax rate applying to those earnings when they are distributed in the future.
Transition tax computations will need to be integrated with your tax return but may require special resources. Bolden International Tax Services can assist clients in understanding these new tax provisions and in establishing timelines and expectations.
