What Is the Section 965 Inclusion Transition Tax?

The Section 965 inclusion, often called the transition tax, was established by the Tax Cuts and Jobs Act of 2017. It marked a shift in how the U.S. taxes the foreign income of American-owned businesses. The provision created a one-time tax on the accumulated and previously untaxed foreign earnings of certain foreign corporations. These earnings were treated as if they had been brought back, or repatriated, to the United States.

The purpose of this tax was to facilitate the move from a worldwide tax system to a territorial one. Under the prior system, U.S. companies were often incentivized to keep profits offshore to defer U.S. taxation. The transition tax addressed these accumulated offshore earnings, clearing the way for a new system where future foreign profits could be repatriated with a lower tax burden.

Identifying Affected Taxpayers and Corporations

The Section 965 tax applies to a “U.S. shareholder” who owns a stake in a “Specified Foreign Corporation” (SFC). A U.S. shareholder is a U.S. person, such as an individual or domestic corporation, that owns 10% or more of the voting power or value of a foreign corporation. Both corporate and individual shareholders can be subject to the tax.

An SFC includes two main types of foreign entities. The first is a Controlled Foreign Corporation (CFC), where U.S. shareholders own more than 50% of the vote or value. The second is any foreign corporation that is not a CFC but has at least one domestic corporation as a U.S. shareholder. A Passive Foreign Investment Company (PFIC) that is not also a CFC is generally excluded from being an SFC.

The tax applies to the accumulated post-1986 deferred foreign income of the SFC. This income is measured as the greater of the amount held on two specific dates: November 2, 2017, or December 31, 2017. This look-back feature required taxpayers to analyze their foreign corporations’ financial positions at both points to identify the correct earnings base for the tax.

Calculating the Net Tax Liability

To calculate the tax, a U.S. shareholder must first follow an aggregation rule. This rule requires the shareholder to sum the positive post-1986 earnings and profits (E&P) from all of their SFCs. If a shareholder also owns SFCs with E&P deficits, those deficits can be used to offset the positive E&P from other SFCs. This netting process results in the shareholder’s aggregate foreign E&P.

The next step is to calculate the shareholder’s pro-rata share of that aggregate amount based on their ownership percentage. This share becomes the gross Section 965 inclusion amount that must be reported as income. This is a “deemed repatriation,” meaning the shareholder is taxed as if they received a distribution of these earnings, even if no cash was transferred. This gross inclusion is the starting point before any deductions are applied.

A participation deduction is then applied, which lowers the effective tax rate on the included income. For the portion of E&P held as cash or cash equivalents, the deduction results in a 15.5% tax rate. For the remaining E&P, representing earnings reinvested in other assets, a larger deduction applies, leading to an 8% tax rate.

Reporting Requirements and Payment Elections

A taxpayer subject to the transition tax must file Form 965, “Inclusion of Deferred Foreign Income Upon Transition to Participation Exemption System,” with their income tax return for the year of inclusion. Taxpayers must also attach an “IRC 965 Transition Tax Statement” to their return. This statement must contain specific information for each SFC, including the E&P measurement date amounts, any deficits used, and the calculation of the aggregate cash position.

Taxpayers could elect to pay the net tax liability in installments over an eight-year period without interest. This election had to be made by the due date of the tax return for the inclusion year and could not be made later. Making the election required a timely filed return and the attachment of a statement affirming the choice.

The payment schedule for this election is back-loaded. It requires payment of 8% of the total tax liability for each of the first five years. The remaining liability is paid in increasing installments: 15% in year six, 20% in year seven, and the final 25% in year eight.

Post-Inclusion Year Implications

A primary consequence of a Section 965 inclusion is the creation of Previously Taxed Earnings and Profits (PTEP). When a U.S. shareholder pays the transition tax on their share of foreign earnings, those earnings are reclassified as PTEP.

Tracking this PTEP is necessary to prevent double taxation. When the foreign corporation later makes an actual cash distribution from these earnings, the shareholder can receive it tax-free up to their PTEP balance. Without proper tracking, these distributions could be incorrectly taxed a second time.

For taxpayers who chose the installment plan, there is an ongoing obligation to make annual payments. Failure to make a scheduled payment can have consequences. Certain events, such as selling the business or an individual shareholder renouncing citizenship, can trigger an acceleration of the remaining unpaid installments, making the entire balance due immediately.