How to Apply the Section 965(b) E&P Deficit Rule

The Tax Cuts and Jobs Act of 2017 (TCJA) introduced Internal Revenue Code Section 965, which imposed a one-time transition tax on the accumulated and previously untaxed foreign earnings of certain foreign corporations owned by U.S. shareholders. This measure deemed those offshore profits to have been brought back to the United States, subjecting them to a mandatory tax. The tax was applied to the foreign corporation’s last taxable year beginning before January 1, 2018.

Within this framework, Section 965(b) provides relief. It allows U.S. shareholders who own multiple foreign corporations to reduce their overall transition tax liability. This provision permits the shareholder to offset the taxable income from profitable foreign corporations with the accumulated deficits from unprofitable ones. This netting mechanism can lower the shareholder’s total Section 965(a) inclusion amount, which is the base income subject to the transition tax.

Identifying Relevant Foreign Corporations

To apply the deficit rule, a taxpayer must be a “U.S. Shareholder,” which is a U.S. person or entity owning 10 percent or more of a foreign corporation’s stock. The taxpayer must then categorize each “Specified Foreign Corporation” (SFC) they own. An SFC is a controlled foreign corporation (CFC) or another foreign corporation with at least one U.S. corporate shareholder.

Once identified, all SFCs must be sorted into two groups. The first is “Deferred Foreign Income Corporations” (DFICs), which are SFCs with accumulated post-1986 deferred foreign income greater than zero as of a measurement date. These corporations’ positive earnings create the initial tax inclusion under Section 965(a). The second group is “E&P Deficit Foreign Corporations,” which are SFCs with a deficit in their post-1986 earnings and profits (E&P). It is the deficits from these corporations that can be used to reduce taxable income.

Calculating the Aggregate Foreign E&P Deficit

After identifying all E&P Deficit Foreign Corporations, the next step is to calculate the “aggregate foreign E&P deficit.” This figure represents the total relief available to offset income from profitable corporations. The calculation is a summation of the individual E&P deficits from every E&P Deficit Foreign Corporation owned by the U.S. shareholder, consolidating all qualifying deficits into a single number.

The amount of the E&P deficit for each corporation is determined as of a specific date. The law requires measuring the accumulated post-1986 E&P on two dates: November 2, 2017, and December 31, 2017. The relevant figure for an E&P deficit corporation is the amount on whichever of these two dates the deficit is larger. This dual-date measurement prevents manipulation of E&P balances.

Allocating the Deficit to Reduce Inclusion Income

The aggregate foreign E&P deficit is used to reduce the income inclusion from DFICs. The law mandates that this deficit be allocated among all of the U.S. shareholder’s DFICs on a pro-rata basis. The amount of deficit allocated to a specific DFIC is determined by the ratio of that DFIC’s positive accumulated E&P to the aggregate positive E&P of all the shareholder’s DFICs. This ensures a DFIC with larger income receives a correspondingly larger share of the deficit offset.

For example, consider a U.S. shareholder with a total aggregate foreign E&P deficit of $100. The shareholder also owns two DFICs: DFIC A with $300 of positive E&P and DFIC B with $100 of positive E&P. The total positive E&P is $400. DFIC A represents 75% of the total positive E&P ($300 / $400), so it would be allocated $75 of the deficit. DFIC B, representing 25% ($100 / $400), would be allocated the remaining $25. Consequently, the shareholder’s taxable inclusion from DFIC A is reduced to $225, and from DFIC B to $75.

This allocation directly reduces the Section 965(a) inclusion amount for each DFIC. The earnings offset by this deficit allocation become Section 965(b) previously taxed earnings and profits (PTEP). While not taxed, these amounts have specific basis and distribution ordering rules that affect future transactions.

Required Reporting and Documentation

Applying the Section 965(b) deficit rule requires specific reporting with the U.S. shareholder’s income tax return. Taxpayers must file Form 965, “Inclusion of Deferred Foreign Income Upon Transition to Participation Exemption System,” which is the primary document for reporting all Section 965 calculations. This form is required even if the aggregate deficit fully offsets the inclusion amount, resulting in no net tax liability.

Accompanying Form 965 are several schedules that provide detailed calculations, such as Schedule C, “U.S. Shareholder’s Aggregate Foreign E&P Deficit.” Schedule C is where the taxpayer lists each E&P deficit foreign corporation and its respective deficit. Depending on the ownership structure, Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations,” may also be required.

A “Section 965(b) Deficit Allocation Statement” must also be attached to the tax return. This statement provides the IRS with a breakdown of the deficit allocation. It must include the name of each E&P deficit foreign corporation, the specified E&P deficit of each, and detail the allocation of that deficit to each DFIC.