Section 965 Income and the One-Time Transition Tax

Section 965 of the Internal Revenue Code, introduced by the Tax Cuts and Jobs Act of 2017 (TCJA), established a one-time mandatory tax on previously untaxed foreign earnings of certain U.S. shareholders in foreign corporations. This “transition tax” was a component of the move from a worldwide tax system to a territorial system that primarily taxes domestic income. The tax is often called a “deemed repatriation” tax because it treats accumulated foreign profits as if they were brought back to the United States for a one-time levy. The purpose was to bring years of untaxed foreign earnings into the U.S. tax base before the new territorial system took full effect, effectively creating a bridge between the two tax regimes.

Determining Applicability for the Transition Tax

The transition tax applies to a “United States shareholder” of a “specified foreign corporation” (SFC). A U.S. shareholder is defined as a U.S. person—which can be a citizen, resident, domestic corporation, partnership, or trust—that owns at least 10% of the total combined voting power or value of a foreign corporation.

An SFC is a term that encompasses two main types of foreign entities. The first is a Controlled Foreign Corporation (CFC), which is any foreign corporation where U.S. shareholders own more than 50% of the total combined voting power or value. The second category includes any foreign corporation, other than a passive foreign investment company (PFIC), that has at least one U.S. corporation as a U.S. shareholder.

To be subject to the tax, an individual or business must meet both criteria. For example, if a U.S. citizen owns 15% of a foreign company, they meet the U.S. shareholder definition. If other U.S. persons also own shares, and collectively their ownership exceeds 50%, that foreign company is a CFC, and therefore an SFC. The 15% owner would then be subject to the tax on their share of the company’s untaxed earnings.

The law applies to the last taxable year of the SFC that began before January 1, 2018. The U.S. shareholder must then include their share of this income in their own tax year in which the SFC’s year ends.

Calculating the Section 965 Income Inclusion

The calculation begins with a specified foreign corporation’s post-1986 accumulated earnings and profits (E&P). The law requires measuring E&P on two dates: November 2, 2017, and December 31, 2017. A shareholder’s income inclusion is based on their pro-rata share of the greater of the E&P on these dates, a rule that prevented companies from artificially reducing their E&P.

The E&P is segregated into two categories. The first is the portion held in cash or cash equivalents, such as currency and bank deposits. The second category includes all other E&P, representing non-cash assets like property, plant, and equipment.

The calculation includes a participation deduction that lowers the tax liability. Instead of standard income tax rates, a deduction is calculated to produce an effective tax rate of 15.5% on the cash portion of the E&P and 8% on the non-cash portion.

For example, a U.S. corporate shareholder with a $1 million pro-rata share of E&P, split between $600,000 in cash and $400,000 in non-cash assets, would have a net tax liability of $125,000. This results from a 15.5% tax on the cash portion and an 8% tax on the non-cash portion. Taxpayers may also use foreign tax credits to reduce this liability, though limitations apply.

Paying the Transition Tax Liability

A taxpayer can elect to pay the net tax liability in installments over eight years. This election eases the financial burden of a large, one-time tax bill. The election must be made by the due date of the tax return for the year of the income inclusion.

The installment schedule is back-loaded, requiring smaller payments in the initial years.

• Years 1-5: 8% of the total tax liability is due annually.
• Year 6: 15% of the total liability is due.
• Year 7: 20% of the total liability is due.
• Year 8: The final 25% of the liability is due.

If certain “acceleration events” occur, the entire remaining unpaid balance of the transition tax becomes immediately due and payable. Common events include failing to make a payment on time, liquidating the business, or selling substantially all its assets.

Taxpayers who have made the installment election must be mindful of these provisions. A late payment or a significant change in business structure could trigger an immediate demand for the full remaining tax debt.

Reporting and Filing Requirements

Reporting the Section 965 income inclusion requires specific forms. The primary document is Form 965, Inclusion of Deferred Foreign Income Upon Transition to Participation Exemption System, which must be filed with the income tax return for the year of the inclusion.

Form 965 is accompanied by schedules that break down the calculation. Schedule A is used to report a shareholder’s pro-rata share of E&P and cash position. Schedule H, Election to Pay Net Tax Liability in Installments, must be completed by taxpayers choosing to pay over time.

Taxpayers are also required to attach an ‘IRC 965 Transition Tax Statement’ to their return. This statement summarizes figures like the total income inclusion, the aggregate foreign cash position, and the net tax liability. This statement must be filed in the year of inclusion and in each subsequent year that an installment payment is made.

The income inclusion is also reported on other international information returns, such as Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. Failure to meet these specific reporting requirements can lead to penalties.