IRC Section 965 – Transition Tax (Tax Cuts & Jobs Act)

Glimpse of Article:

From 20th January, 2017, when he started his presidency in USA, he has always been the topic of discussion and lime light for all the people around the world due to his bold decisions and his speeches. So, I think now it doesn’t require to mention the name of this great leader or businessman, whatever you want to say. Changes in Immigration rules, Visa Rules and Tax Law are major highlights of them. After reading this article, you will come to know, what is section 965, which is newly come into place because of tax cuts and jobs Act and main reason to bring this new section.

History Before the Tax & Cuts Jobs Act:

In the year 1962, IRS has introduced concept of Subpart–F income. U.S. Code Section 951 gives IRS right to include prorated share of Subpart-F income in the income of U.S Shareholder of controlled foreign corporation (CFC). Income inclusion is covered by Section 953 (Certain Insurance income), 954 (Foreign base company income) and 956 (Investment of property in USA by Foreign corporation).

CFC means any foreign corporation that is controlled more than 50% by any U.S. Shareholder. ( U.S Shareholder can be U.S. individual or US Domestic Corporation.)

Why change in tax law is so important?

In the December 2017, IRS has come up with the major tax reform along with the change in tax law for taxpayers having international presence and income from the locations outside United States of America. If you are associated with any US corporation or individual which has international presence, you must have seen that they are really worried about this tax law change. Why is it so? The reason is as below:

With this tax reform, IRS has laid down completely new category of income and tax for the US shareholder of Controlled foreign corporation (CFC) named GILTI (Section 951A) and mandatory Repatriation Tax (Section 965). GILTI Stands for Global Intangible Low Taxed Income, which is defined as excess income earned on Foreign Qualified Business Asset Investment along with certain deductions and foreign tax credit specified in law. In this article, our focus will be on understanding the concept of section 965 Tax.

What is section 965 Tax?

Section 965 Tax is mandatory repatriation or transition tax, which is calculated on untaxed Post 1986 Earnings & Profits of Corporation (E&P). Now, here the main question is, what is E&P and why IRS has introduced tax on it? So, E&P in layman language is retained earnings. Now, you must have understood that, by this new provision, IRS is trying to tax the income which was not taxed earlier and never repatriated to USA, but its accumulated as E&P or you can say retained earnings.

Generally, you can find the balance of E&P from Schedule J of form 5471. Form 5471 is an informational form to be filled every year by US director, officer or share holder who is holding at least 10% of foreign corporation.

Section 965 is applicable to US Shareholder of Specified Foreign Corporation, which is defined under section 965 (e) to include any Controlled Foreign Corporation (CFC).

Deduction available for Sec. 965 inclusion (Sec. 965 (c)):

Deduction available for section 965 depends on the type of assets, in which foreign corporation has invested its Earnings & Profits.

·        For Cash Portion: 55% Deduction you will get as deduction of total cash position held. Here, Cash Position includes cash equivalents, Accounts Receivable and we need to exclude Accounts payable.

·        For Other assets: 77% Deduction will be available for the portion of E&P, invested in assets other than cash position.

Reporting of Section 965 Income inclusion and deduction on tax return:

Following are the Line number on returns on which we need to report section 965 Income inclusions and deductions respectively:

·        C Corporation Return (1120): IRC 965 Transition Tax Statement, Line 1 and Line 3.

·        S Corporation Return (1120S): Page 3, Schedule K Line 10 and Line 12b.

·        Partnership Return (1065): Page 4, Schedule K, Line 11 and Line 13d.

·        Individual Return (1040): Inclusion less deduction on Page 1, Line 21 (Other income).

Tax on Section 965 income inclusion:

Here, Deduction under section 965 (c) is structured in a way that, Effective income tax rate for cash position would be 15.5% and for non-cash portion, it would be 8%.

Deferral of Tax payment:

Section 965 is completely a new category of income for the US Shareholder, who is holding more than 10% of Specified foreign corporation (which is CFC). From looking to above scenario and reading provisions, anybody would find it very harsh. And, Yes, actually, it is very harsh, who has never repatriated any income to USA.

So, IRS does not want to be so harsh for the taxpayers who has section 965 income. So, accordingly IRS has given option to Defer the payment of 965 transition tax. Deferral option is available as follows:

·        Other Than S corporation: Tax payer can defer payment for 8 years. (8% in first 5 years, 15%, 20% and 25% in respective 3 years.)

·        For S Corporation shareholder: S Corporation can differ it indefinitely unless there is triggering event (which is, cessation of S Corp. Business or Shareholder sold the shares).

To get this deferral option, taxpayer needs to file election with IRS along with payment of 8% tax by original due date of return (i.e., 15th March OR 15th April) and not the extended due date.

Please note that, now when actually this E&P is repatriated or distributed to US Shareholder in future, it will be tax free, as it is already taxed once.

Conclusion:

By this change in Tax Law, IRS has not left any way for US Shareholder to evade tax by earning income in foreign territory and defer it for infinite period by not repatriating it to USA. Along with the inclusion of section 965 income as increase in Subpart F income, there is also need to consider new mechanism of GILTI tax and FDII (Foreign Derived Intangible Income). Believe it or not, GILTI can be really very much GUILTY to whom it is applicable.

On this note, its Goodbye from my side, until I write another article.

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