U.S. shareholders of foreign corporations – transition tax due date quickly approaching
Published March 28, 2018
Caution to U.S. taxpayers with 10% ownership in specified foreign corporations – first installment of transition tax due on or before April 17, 2018 or lose right to pay transition tax in installments over 8 years.
The Tax Cuts and Jobs Act (“TCJA”) transformed the U.S. corporate income tax system from a worldwide system to one that is more akin to a territorial system. Under the prior system, it was possible for U.S. shareholders to defer U.S. taxation of the foreign profits of foreign corporations. As a result, many U.S. based multinationals, as well as many U.S. individual shareholders, caused their foreign corporations to refrain from repatriating foreign profits.
To transition from the old worldwide system to the new quasi-territorial system, TCJA also introduced a one-time mandatory transition tax on the previously untaxed income of any “deferred foreign income corporations” (DFICs). The transition tax is effective for the last tax year of any DFIC beginning before January 1, 2018; but it is not imposed on the DFIC itself, but is imposed on any U.S. shareholders owning 10% or more of the DFIC, including shareholders that are individuals, for their tax year(s) in which the relevant tax year of the DFIC ends. For example, a U.S. shareholder with a December 31 tax year, owning a DFIC that also reports on a calendar year basis, the transition tax would apply to the U.S. shareholder’s 2017 tax return.
If the DFIC has a fiscal year end (those with year ends other than December 31, 2017), the income inclusion would be in the U.S. shareholder’s 2018 income tax return.
For purposes of illustration, the following discussion is based on a DFIC with a December 31 year end that is owned by a U.S. shareholder with a December 31 year end.
Pursuant to the TCJA, the Internal Revenue Code Section (“IRC §”) 965 states that U.S. taxpayers will pay the tax at reduced rates on their pro rata share of the DFIC’s post-1986 deferred foreign income (DFI). The tax rate reduction is achieved via a special deduction that is intended to function as a partial participation exemption. Effectively, a U.S. shareholder that is a corporation will pay tax at a 15.5% tax rate on an amount of DFI equal to the cash or cash equivalent position of the DFIC, and an 8% tax rate on any DFI in excess of the DFIC’s cash position. The effective tax rates for individual shareholders are slightly higher for inclusions on their 2017 returns, and considerably higher for inclusions on their 2018 returns.
Notably, taxpayers are permitted to elect to pay the tax liability associated with the mandatory inclusion in eight annual installments. The installments are heavily weighted to the last three years. For the first five installments (with the first applying to 2017), the taxpayer will pay 8% per year; the 6th installment at 15%; the 7th installment at 20%; and the 8th and final installment at 25%.
It is critical to note that if a shareholder elects to pay in installments, the entire deferred balance is accelerated upon the occurrence of any of the following:
- failure to timely pay any required installment
- liquidation or sale of substantially all the assets of the taxpayer (including a Chapter 11 bankruptcy)
- cessation of the business by the taxpayer or
- any similar circumstance
A calendar year taxpayer wishing to pay in installments MUST elect to do so in their 2017 federal income tax return. The most important consideration is that the first installment must be paid on or before the original due date of the taxpayer’s 2017 income tax return, April 17, 2018. Failure to remit the first 8% installment on or before April 17, 2018 will result in loss of the right to defer payments. In other words, the full tax would be due by April 17, 2018.
In March 2018, the IRS issued a question and answer document that outlined the process for making a 965 Payment. The 965 Payment must be made either by wire transfer, check or money order. The 965 Payment may be paid in full or the first installment of the full 965 Payment if an election is made to defer payment over eight installments as noted above. On a wire payment of tax owed under section 965 of the Code, the taxpayer would use a 5-digit tax type code of 09650 (for more information, see the information on the IRS website on Same-Day Wire Federal Tax Payments). A check or money order payment of tax owed resulting from section 965 of the Code, needs to include an appropriate payment voucher (such as Form 1040-V or 1041-V) along with all other required information, it is also necessary to write on the front of your payment “2017 965 Tax.” The 965 Payment must be made separately from any other tax payment.
For S corporation shareholders, special rules apply that effectively permit indefinite deferral of the repatriation tax until the S corporation is sold, liquidated, or otherwise disposed of. In order to take advantage of the S Corp deferral, an election MUST be made with the shareholder’s 2017 income tax return. Contact Kevin Heyde, CPA via e-mail or phone (502.882.4475) for more information.