By David W. Achey, CPA, MST
The Section 965 “transition tax” is a key piece of the Tax Cuts and Jobs Act of 2017 (TCJA). It is the vehicle that moves the U.S. approach to international taxation from a worldwide system to a quasi-territorial system. The effect of Section 965 is a deemed repatriation of the accumulated earnings of controlled foreign corporations (CFCs) and other “specified foreign corporations” (SFCs) with U.S. owners. The transition tax is applicable to an SFC’s last tax year beginning before Jan. 1, 2018.
Section 898 generally requires conformity of a CFC’s tax year to its controlling U.S. shareholder’s tax year. For many U.S. owners of foreign corporations, the transition tax was a major item of consideration for their 2017 tax liabilities and reporting. For shareholders of SFCs with a fiscal year and no controlling U.S. parent, the transition tax will in many cases be applicable to the 2018 tax year. For example, a calendar year U.S. shareholder of a foreign corporation with a fiscal year end of March 31, 2018, would calculate any transition tax for the shareholder's 2018 tax year.
2018 Tax Forms, and 2017 and 2018 Reporting
As a rule, tax returns and schedules are filed on an annual accounting basis. In the case of the transition tax, the IRS was not prepared to create the relevant forms in time for the 2017 tax year, resulting in significant uncertainty regarding the level of detail that would ultimately be reported. The IRS took a retroactive approach, requiring full disclosure of the Section 965 calculations – and detailed reporting for both applicable years at the same time – with the 2018 tax returns.
The IRS released Form 965, along with supporting schedules and instructions, to report the calculation and payment of Section 965 transition tax for both 2017 and 2018 tax years. It may come as a surprise that Form 965 may be required even if no net Section 965 inclusion is calculated for a U.S. shareholder. If each of the foreign corporations for which a taxpayer is a U.S. shareholder was in an accumulated deficit position at the applicable measurement date(s), then it appears that no reporting is required. If a taxpayer had no net Section 965 inclusion because the positive earnings and profits of one foreign corporation was less than the deficits of the other foreign corporation(s), then Form 965 and the related detail schedules must be completed. Taxpayers receiving Section 965 inclusion information from pass-through entities also file Form 965, but the reporting requirements are more limited. Inclusion and deduction amounts are required to be reported (with detail in an attachment by pass-through entity and foreign corporation), but the underlying calculations do not need to be provided.
Section 965 inclusions for each year must also be reflected on Form 5471. The form received a significant update for 2018, with several new and expanded schedules, as well as the addition of new Category 1 filing requirements for U.S. shareholders of SFCs. Schedules J and M of Form 5471 report the earnings and profits of the foreign corporation and each U.S. shareholder’s proportion of previously taxed income (including Section 965 inclusions), respectively. Any adjustments to earnings and profits for allocations of accumulated earnings from an SFC with accumulated earnings to another SFC with a deficit must also be presented.
How Are 2017 and 2018 Overpayments Applied?
For taxpayers who elected to pay their transition tax in installments, the IRS has consistently taken the position that any 2017 overpayment will be applied first to any and all installments of Section 965 tax, and only then will any excess be applied to 2018. The IRS’s stance is that the tax is a 2017 liability, so all 2017 payments will be applied to it. Similarly, if a taxpayer has a 2018 Section 965 tax liability, any 2018 overpayment will be applied to future installments of that liability before any excess is carried to 2019. However, 2018 overpayments of estimated tax would not automatically be applied to the 2017 tax installments, because the payments were made for a different tax year.
The Section 965 transition tax has resulted in significant complexity and increased reporting responsibilities for U.S. shareholders of foreign corporations. Taxpayers’ 2018 tax returns are key to properly disclosing the supporting calculation of any Section 965 tax liability, for both 2017 and 2018. Practitioners will need to allow adequate time to understand the new forms and schedules, and consultation with an international tax specialist is recommended.
David W. Achey, CPA, MST, is a manager in the tax services group at RKL LLP, Certified Public Accountants and Consultants. He is also a member of PICPA’s International Tax Advisory Board.
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