What Is a Section 965 Specified Foreign Corporation?

The Tax Cuts and Jobs Act of 2017 (TCJA) changed how the foreign earnings of U.S.-owned corporations are treated. A component of this reform was Internal Revenue Code Section 965, which established a one-time transition tax on certain untaxed foreign earnings. In the 2024 case Moore v. United States, the Supreme Court upheld this tax. The tax was designed to facilitate the move from a worldwide tax system to a territorial system that largely exempts foreign-sourced dividends.

This transition tax required U.S. owners of certain foreign corporations to treat their accumulated and previously untaxed overseas profits as if they had been repatriated to the United States. This “deemed repatriation” triggered a mandatory U.S. tax liability on those earnings. The tax applied to the final tax year of these foreign corporations that began before January 1, 2018.

Defining a Specified Foreign Corporation

A Specified Foreign Corporation (SFC) is a foreign entity subject to the transition tax. The definition includes two main types of foreign corporations. The first is a Controlled Foreign Corporation (CFC), and the second is any other foreign corporation that is not a passive foreign investment company (PFIC) but has at least one U.S. corporation as a shareholder.

A passive foreign investment company, which earns passive income like interest and dividends, is excluded from the SFC definition unless it also qualifies as a CFC. Identifying whether a foreign entity meets the SFC criteria is the initial step for any U.S. person or entity in assessing their potential obligations.

Controlled Foreign Corporation (CFC) Explained

A foreign corporation is classified as a CFC if U.S. Shareholders own more than 50% of either the total combined voting power or the total value of the corporation’s stock. This ownership test is applied on any day during the foreign corporation’s taxable year. The ownership rules are broad and include not just direct ownership but also indirect and constructive ownership, which can attribute stock ownership between related parties.

U.S. Shareholder Definition

A “U.S. Shareholder” is a “U.S. person” who owns 10% or more of the foreign corporation’s stock, measured by either voting power or value. A “U.S. person” is broadly defined and includes U.S. citizens and residents, domestic corporations, domestic partnerships, and certain trusts and estates. Even if a foreign corporation is majority-owned by foreign persons, a U.S. person holding a 10% or greater stake is considered a U.S. Shareholder.

Key Measurement Dates

Two specific dates were established to measure a foreign corporation’s status as an SFC and its accumulated earnings: November 2, 2017, and December 31, 2017. A foreign corporation had to be an SFC on at least one of these dates to be subject to the tax. These dates were also used to determine the amount of post-1986 earnings and profits (E&P) subject to the tax, with the law requiring taxpayers to use the greater of the two amounts.

Calculating the Section 965 Net Tax Liability

The calculation of the net tax liability is a multi-step process. It begins with identifying the income to be included, allows for certain reductions and deductions, and culminates in the final tax amount. The starting point is a U.S. Shareholder’s pro-rata share of the foreign corporation’s accumulated post-1986 deferred foreign income.

Step 1: Determine the Inclusion Amount

The first step is to determine the inclusion amount. This amount is the U.S. Shareholder’s share of the specified foreign corporation’s post-1986 E&P, using the greater amount from the two measurement dates. E&P is an accounting measure of a company’s accumulated economic profits available for distribution to shareholders. For this calculation, E&P is determined without reduction for dividends distributed during the relevant tax year, unless those dividends were paid to another SFC.

Step 2: Reduce by the Aggregate Foreign E&P Deficit

After determining the gross inclusion amount from profitable SFCs, a U.S. Shareholder can reduce this amount by their share of deficits from other SFCs they own. This provision allows a shareholder to offset the taxable income from one foreign corporation with the E&P deficits from another. The shareholder must aggregate all of their E&P deficits from their deficit SFCs and use this total to proportionally reduce the inclusion amounts from their profitable SFCs.

Step 3: Calculate the Allowable Deduction

A feature of the transition tax calculation is a deduction that lowers the effective tax rate on the included income. The inclusion is separated into two components: the portion attributable to the SFC’s aggregate cash position and the portion attributable to all other assets. Different deduction percentages apply to each portion, resulting in two different effective tax rates. The portion of the income attributable to cash and cash equivalents is taxed at a higher rate of 15.5% for corporations, while the remaining portion is taxed at a lower rate of 8%.

Step 4: Determine the Final Tax Liability

The final tax liability is determined by applying the U.S. Shareholder’s regular income tax rate for the year to the net taxable income calculated in the previous steps. For a corporate shareholder, this would be the 21% corporate tax rate, while individual shareholders would use their ordinary income tax rate.

The Role of Foreign Tax Credits

U.S. Shareholders can claim a credit for a portion of the foreign income taxes they have already paid or accrued on the earnings being included in their U.S. income. However, these foreign tax credits are subject to a reduction. The amount of the deemed-paid foreign tax credit that can be claimed is reduced in proportion to the deduction taken. This ensures that the tax benefit of the foreign tax credit is aligned with the portion of the income that is subject to U.S. tax.

Available Elections for Section 965

After calculating the total net tax liability, taxpayers were provided with several elections that could alter how and when the tax was paid. These elections were designed to ease the financial burden of the one-time tax and provide flexibility. Making one of these elections required a formal declaration on the taxpayer’s tax return for the year the inclusion was reported.

The Installment Payment Election

The most common election available to all taxpayers with a net tax liability was the option to pay the tax in installments over eight years. This election allowed the taxpayer to pay the liability without incurring interest, provided the installments were paid on time. The payment schedule was back-loaded.

• For each of the first five years, 8% of the total liability was due.
• In the sixth year, the payment increased to 15%.
• In the seventh year, the payment was 20%.
• In the eighth year, the final 25% was due.

The Deferral Election for S Corporation Shareholders

A separate election was available to shareholders of an S corporation that was a U.S. Shareholder of an SFC. These shareholders could elect to defer the payment of their tax liability indefinitely until the occurrence of a “triggering event.” This election postponed the tax payment until the shareholder’s financial situation changed in a specific way. Common triggering events include the S corporation ceasing to be an S corporation, the liquidation or sale of the S corporation’s assets, or the shareholder disposing of their stock.

Election for Real Estate Investment Trusts (REITs)

Real Estate Investment Trusts (REITs) were provided with a special election. Unlike the installment election, the REIT election allowed the REIT to include the income itself over an eight-year period. This meant the REIT could recognize the income and the corresponding deduction in equal parts over eight years. Spreading the income inclusion over time helped REITs manage their annual distribution requirements.

Reporting and Payment Obligations

Compliance with the transition tax involves specific reporting and payment procedures that must be followed to avoid penalties. Taxpayers subject to the tax must file detailed statements with their income tax returns and adhere to strict payment deadlines. Failure to meet these obligations can result in interest and penalties on the unpaid tax.

Required Tax Forms

The central document for reporting the transition tax is Form 965, Transition Tax Statement. This form and its schedules must be attached to the taxpayer’s annual income tax return, such as Form 1120 for corporations or Form 1040 for individuals. In addition to Form 965, taxpayers may also need to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, which provides extensive information about the foreign corporation’s finances.

Making the Election on the Return

Taxpayers make the available elections directly on the Form 965 filed with their tax return. To make the installment payment election, the taxpayer must check the appropriate box on the form and file it with a timely income tax return. The act of filing the form with the election properly made constitutes a binding choice.

Executing Payments

For taxpayers who did not make an election, the full tax liability was due on the unextended due date of their 2017 or 2018 tax return. For those who elected to pay in installments, the first payment was due on the due date of the return, with subsequent annual installments due on the return due dates for the following seven years. The taxpayer is responsible for making timely payments even if an IRS notice is not received, and a missed installment can make the remaining balance immediately due.

Post-Filing Considerations

An important consequence of paying the tax is that the foreign earnings included in income are reclassified as Previously Taxed Income (PTI). This PTI can be distributed back to the U.S. Shareholder in the future without being subject to further U.S. federal income tax. Taxpayers must maintain careful records to track their PTI basis in each foreign corporation to ensure that future distributions are correctly treated as tax-free returns of capital rather than taxable dividends.