Section 965 Tax on a Specified Foreign Corporation (SFC)

The Tax Cuts and Jobs Act of 2017 (TCJA) introduced a one-time levy known as the Section 965 Transition Tax. This tax was part of the United States’ shift from a worldwide system of taxation to a quasi-territorial system. The purpose of this law was to impose a tax on the accumulated and previously untaxed foreign earnings of certain U.S.-owned foreign corporations.

These earnings, which had been deferred from U.S. taxation since 1986, were treated as if they had been brought back, or repatriated, to the U.S. This “deemed repatriation” required U.S. owners to pay tax on their share of these historical foreign profits. The tax applied regardless of whether the cash was physically moved to the United States.

Determining Applicability of the Transition Tax

The transition tax applies specifically to a “U.S. Shareholder” of a “Specified Foreign Corporation” (SFC). A U.S. Shareholder is a U.S. person or entity that owns 10% or more of the total combined voting power of a foreign corporation. This can include domestic corporations, individuals, S corporations, partnerships, and trusts, with rules considering both direct and certain indirect ownership structures.

A Specified Foreign Corporation is primarily any Controlled Foreign Corporation (CFC), which is a foreign corporation where U.S. Shareholders own more than 50% of the vote or value. The definition of an SFC also extends to any other foreign corporation that has at least one domestic corporation as a U.S. Shareholder, even if it is not a CFC. However, a passive foreign investment company (PFIC) that is not also a CFC is excluded from the definition of an SFC.

The tax is triggered for a U.S. Shareholder if their SFC holds untaxed foreign earnings and profits accumulated after 1986. For example, if a U.S. individual owns 15% of a foreign corporation that is majority-owned by other U.S. persons, it qualifies as a CFC. This makes the individual a U.S. Shareholder of an SFC, and if that SFC has positive accumulated earnings not previously subject to U.S. tax, the individual is subject to the transition tax on their pro-rata share.

Calculating the Section 965 Net Tax Liability

The calculation is a multi-step process that begins with determining the shareholder’s mandatory income inclusion. This amount is the shareholder’s pro-rata share of the SFC’s post-1986 earnings and profits (E&P) not previously taxed in the U.S. To establish this amount, the E&P had to be measured on two dates—November 2, 2017, and December 31, 2017—and the greater of the two amounts was used. If a shareholder owns multiple SFCs, they may use E&P deficits from one to offset positive E&P from another.

Once the total inclusion amount is determined, it is divided into two portions based on the SFC’s liquidity. The first portion is the shareholder’s share of the “aggregate foreign cash position.” This cash position includes:

• Cash
• Net accounts receivable
• Actively traded investments
• Other short-term obligations

The residual amount of the E&P not classified as part of the cash position makes up the second, non-cash portion.

A participation deduction is provided to lower the tax rate on the deemed repatriated earnings. The portion of the E&P inclusion attributed to the aggregate foreign cash position is taxed at a higher effective rate of 15.5% for corporate shareholders. The remaining portion of the E&P, representing non-cash assets, is taxed at a lower effective rate of 8%. For individual shareholders, these rates can differ.

From this gross tax liability, taxpayers can then apply a portion of their available foreign tax credits to reduce the U.S. tax owed. These foreign tax credits are subject to a “haircut,” meaning only a percentage of the credits can be used against the transition tax liability. The final amount owed after applying these credits is the net tax liability.

Available Payment and Deferral Elections

After calculating the net tax liability, taxpayers have access to elections that can alter how and when the tax is paid. These elections do not change the total amount of tax owed but provide flexibility for managing the payment obligation. These elections are generally made when filing the tax return for the year of the income inclusion.

The most broadly available option is the Section 965(h) installment election, which allows a taxpayer to pay the amount in eight annual installments. The payment schedule is back-loaded: 8% of the total liability is due in each of the first five years, 15% in year six, 20% in year seven, and the final 25% in year eight. The first installment was due on the original due date of the tax return for the inclusion year, without extensions. Certain events, such as a liquidation or sale of the taxpayer’s assets, can trigger an acceleration of the remaining unpaid installments.

A more specialized deferral is available under Section 965(i) for shareholders of S corporations. This election allows an S corporation shareholder to defer payment of their tax liability indefinitely until a “triggering event” occurs. Triggering events include the S corporation losing its S status, a liquidation or sale of substantially all its assets, or the shareholder transferring their stock. Upon a triggering event, the deferred tax becomes due.

Another election under Section 965(n) allows a taxpayer to not apply any net operating losses (NOLs) against the income inclusion. This can be advantageous for a taxpayer who prefers to preserve their NOLs to offset future income that would otherwise be taxed at higher rates. Each of these elections requires a formal statement to be filed with the tax return.

Compliance and Reporting Requirements

Properly reporting the tax liability requires specific forms and detailed disclosures attached to a taxpayer’s annual income tax return. The primary document for this is Form 965, Inclusion of Deferred Foreign Income Upon Transition to Participation Exemption System. This form is used for reporting the overall calculation, including the income inclusion amount, the related participation deduction, and the resulting net tax liability.

Depending on the taxpayer’s status, additional forms are necessary. Individual taxpayers must file Form 965-A, Individual Report of Net 965 Tax Liability, to report their specific share of the inclusion and tax. Corporate taxpayers file a similar form, Form 965-B. Taxpayers who make an election to pay in installments or defer payment must continue to file these forms annually until the liability is fully paid.

Completing these forms involves transcribing the key data points from the tax calculation, including the shareholder’s pro-rata share of E&P and the aggregate foreign cash position. The forms are also where taxpayers make their formal elections. For example, a taxpayer making an installment or deferral election would indicate this choice on the relevant form or by attaching a required statement.