IRS Notice 2018-13 and the Section 965 Transition Tax

The Tax Cuts and Jobs Act (TCJA) of 2017 introduced changes to the U.S. international tax system. IRS Notice 2018-13 provides guidance on these changes, focusing on the one-time transition tax on foreign earnings accumulated offshore by U.S. companies. This tax was a feature of the tax reform, and the notice provides a framework for understanding and complying with this obligation.

Understanding the Section 965 Transition Tax

The Section 965 transition tax is a one-time tax on the untaxed foreign earnings of certain foreign corporations, known as “specified foreign corporations” (SFCs). The tax applies to the U.S. shareholders of SFCs, targeting the accumulated and unrepatriated earnings and profits (E&P) since 1986. This provision was designed to transition the U.S. from a worldwide tax system to a territorial system by imposing a toll charge on historical offshore profits before the new system took effect.

A U.S. shareholder is a U.S. person who owns 10% or more of a foreign corporation’s stock. The transition tax applies to these shareholders based on their pro-rata share of the SFC’s deferred foreign income. Notice 2018-13 provided definitions and rules for identifying which entities qualify as SFCs and which persons are U.S. shareholders subject to the tax.

Calculating the Transition Tax Inclusion Amount

Calculating the transition tax begins with determining a U.S. shareholder’s share of the “accumulated post-1986 deferred foreign income” for each SFC. This calculation must be performed for two dates, November 2, 2017, and December 31, 2017, with the higher of the two amounts being used. This dual-date system was designed to prevent taxpayers from artificially reducing their foreign earnings to lower their tax liability.

The next step is to calculate the “aggregate foreign cash position,” which is the U.S. shareholder’s pro-rata share of cash and cash equivalents held by their SFCs. Notice 2018-13 clarified that this includes currency, demand deposits, commercial paper, and other highly liquid investments. The aggregate foreign cash position is also measured at specific dates to determine the portion of income subject to a higher tax rate.

The transition tax applies two different rates to the deferred foreign income. The portion of income equal to the aggregate foreign cash position is taxed at 15.5%. The remaining portion, representing earnings reinvested in the business, is taxed at 8%. These rates are achieved through a deduction that reduces the amount of income subject to the standard corporate tax rate.

The final tax liability is the sum of the tax on the cash and non-cash portions. This amount is then reduced by a portion of the foreign tax credits associated with the deferred income. These foreign tax credits are subject to a “haircut,” meaning only a percentage of the credits can be used to offset the transition tax liability.

Available Elections and Payment Options

Taxpayers can manage the payment of this one-time tax through several elections. An election under Section 965(h) allows a taxpayer to pay the net tax liability in installments over eight years. The payment schedule is back-loaded: 8% of the liability is due in each of the first five years, 15% in the sixth year, 20% in the seventh year, and the final 25% in the eighth year.

Shareholders of S corporations have a special election available under Section 965(i) to defer payment of their portion of the tax liability indefinitely until a “triggering event” occurs. Triggering events include the S corporation losing its status, the shareholder selling their stock, or the sale of substantially all of the S corporation’s assets.

Under Section 965(m), a Real Estate Investment Trust (REIT) can elect to treat the income inclusion from the transition tax as income not subject to REIT distribution requirements. This allows the REIT to retain funds to pay the tax over the eight-year installment period without risking its REIT status. The REIT can then pass the inclusion through to its shareholders over several years.

Making any of these elections requires filing a specific statement with the tax return for the year of inclusion. The statement must identify the election being made and provide the necessary calculations and information. For example, the installment election statement must show the total net tax liability and the amount of the first installment payment.

Interaction with the Section 245A Deduction

The TCJA also introduced Section 245A, which provides a 100% dividends received deduction for certain dividends from a specified 10%-owned foreign corporation, creating a territorial tax system for future earnings. A question arose as to how income taxed under the transition tax would be treated when distributed. Notice 2018-13 provided ordering rules to address this interaction.

Income included under the transition tax becomes “previously taxed income” (PTI). This designation allows PTI to be distributed to U.S. shareholders without being subject to U.S. tax again. The notice clarified the creation and tracking of PTI resulting from the transition tax.

The guidance established ordering rules to ensure that distributions from a foreign corporation are treated as coming first from PTI, including the PTI generated by the Section 965 inclusion. When a U.S. shareholder receives a cash dividend from their foreign subsidiary, the distribution is first sourced from PTI accounts. Because this income has already been taxed, the distribution is not taxed again, and the shareholder cannot also claim a Section 245A deduction on that amount.

Required Reporting and Disclosures

Compliance with the transition tax requires attaching a “Section 965 Transition Tax Statement” to the taxpayer’s income tax return for the year of the inclusion. This statement is the primary document for reporting all relevant calculations and elections related to the tax.

The statement must contain a detailed breakdown of the transition tax calculation. This includes the deferred foreign income, the aggregate foreign cash position, the resulting deduction, and the calculation of any foreign taxes deemed paid and disallowed.

In addition to the calculations, the statement must list any elections the taxpayer is making, such as the installment payment plan or the deferral for S corporation shareholders. The statement must also disclose the net tax liability and how it is being paid or deferred.

The IRS also requires the filing of Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations,” for SFCs. Taxpayers must also maintain documentation to support their calculation of the aggregate foreign cash position.