Treasury Issues Guidance on Transition Tax under Section 965

On August 1 2018, the Treasury Department issued regulations relating to the Section 965 transition tax created by the Tax Cuts and Jobs Act (TCJA).  The TCJA changed the way U.S. companies are taxed on their foreign earnings and the transition tax bridges the gap between the old and new rules. To help you understand Section 965, we're providing some explanation and background into this topic as well as recent updates from Supreme Court rulings. 

What is Section 965?

First, Section 965 of the Internal Revenue Code addresses the transition from a global tax system to a territorial tax system for United States corporations. Under the old rules, U.S. companies had to pay residual taxes when they repatriated earnings from low-tax foreign jurisdictions.  This incentivized U.S. companies to keep such earnings abroad. According to the Joint Committee on Taxation, approximately $2.6 trillion of untaxed foreign income has been stockpiled abroad by U.S. corporations.

Under the new rules, U.S. companies repatriating foreign earnings will receive a 100-percent dividend received deduction, which means such income will be exempt from U.S. taxation (unless certain anti-abuse rules apply). The new rules represent a territorial-style tax system instead of a worldwide approach.

The transition from a worldwide tax system to a territorial-style tax system required a provision that would differentiate between the untaxed foreign earnings stockpiled abroad under the old rules and the post-tax reform foreign earnings that are provided an exemption from U.S. tax. Section 965 makes this distinction by establishing a one-time deemed repatriation of all untaxed foreign earnings accrued as of the last taxable year before January 1, 2018.

Categories of foreign earnings under Section 965

The transition tax under Section 965 applies to two categories of foreign earnings—cash and cash equivalents and all other assets.  The tax on cash and cash equivalents is 15.5% and the tax on all other assets is 8%.

This tax is deemed repatriated, meaning companies have to pay this tax regardless of whether they bring the assets into the United States. To ease this burden, companies can choose to pay the tax in installments over eight years. This provision ensured that U.S. companies can transition smoothly to the new territorial tax system, which exempts he fictional repatriation created by Section 965 means some companies may not have the wherewithal to pay the new tax all at one time. Policymakers accounted for this issue by establishing an installment payment option that allows taxpayers to remit payment over an eight-year period.

Guidance surrounding Section 965

Taxpayers have been waiting for guidance to get a better understanding of how certain elections will work under Section 965, and to gain insight into how the new provision will interact with existing provisions like the foreign tax credit. The proposed guidance provides taxpayers with additional information in the following areas:

1. General rules and definitions
2. Determination and treatment of deductions
3. Disregarded transactions
4. Foreign tax credit treatment
5. Elections and payments
6. Affiliated and consolidated group rules
7. Dates of applicability

Below are three excerpts relating to S corporations, the foreign tax credit, and the installment payment option that will be relevant for many taxpayers.

Section 965 for S Corporations

The proposed guidance confirms that, in the case of any S corporation that is considered a U.S. shareholder, each shareholder of the S corporation may elect to defer payment of the shareholder’s net tax liability under Section 965 with respect to the S corporation until the shareholder’s tax year which includes the triggering event with respect to such liability.

The guidance offers additional detail by establishing the process that should be followed when a triggering event occurs.

If a triggering event occurs, Code Sec. 965(i)(4) permits a taxpayer to make an election under Code Sec. 965(h) with respect to the liability to which the Code Sec. 965(i) election applied by the due date for the return of tax for the tax year in which the triggering event occurred, and the first installment under Code Sec. 965(h) must also be paid by the due date (without regard to extensions) for the return for the tax year of the triggering event. However, the election may only be made with IRS’s consent in the case of a triggering event that is a liquidation or sale of substantially all of the assets of the S corporation. (Code Sec. 965(i)(4)(D))

Section 965 and the Foreign Tax Credit

The guidance also provides insight into the interaction with the foreign tax credit. The rules state that no credit is allowed under Sec. 901 for the applicable percentage of any taxes paid or accrued with respect to any amount for which a section 965(c) deduction is allowed.

The term “applicable percentage” means the amount (expressed as a percentage) equal to the sum of the following two amounts: 

1. 0.771 multiplied by the ratio of 
   1. The section 965(a) inclusion amount in excess of the U.S. shareholder’s aggregate foreign cash position divided by
   2. The section 965(a) inclusion amount, and
2. 0.557 multiplied by the ratio of 
   1. The amount of the section 965(a) inclusion amount equal to the United States shareholder’s aggregate cash position, divided by
   2. The section 965(a) inclusion amount.

Further, no deduction is allowed for any tax for which credit is not allowable under Code Sec. 901 by reason of Code Sec. 965(g)(1) (determined by treating the taxpayer as having elected the benefits of subpart A of part III of subchapter N).

Paying the transition tax in installments

With respect to the installment payment option, a U.S. shareholder may elect to pay, in eight installments, the “net tax liability” under Sec. 965, defined as the excess (if any) of:

1. The taxpayer’s net income tax for the tax year in which an amount is included in the gross income of the shareholder under Code Sec. 951(a)(1) by reason of Code Sec. 965, over
2. The taxpayer’s net income tax for such tax year determined 
   1. Without regard to Code Sec. 965, and
   2. Without regard to any income or deduction properly attributable to a dividend received by the shareholder from any DFIC. (Code Sec. 965(h)(6))

For this purpose, the term “net income tax” means the regular tax liability reduced by the credits allowed under subparts A, B, and D of part IV of subchapter A. (Code Sec. 965(h)(6)(B))

If a taxpayer makes an election under Code Sec. 965(h), the first installment is due on the due date (without regard to extensions) for the return of tax for the inclusion year (Code Sec. 965(h)(2)) and each successive installment is due on the due date (without regard to extensions) for the return of tax for the tax year following the tax year for which the previous installment payment was made.

Recent developments in Section 965

In June 2024, the Supreme Court upheld the constitutionality of the Section 965 transition tax that only applies to passthrough entities. The case, Moore, No. 22-800, began when Charles and Katherine Moore sued over the Section 956 transition tax, which the Supreme Court referred to as the "mandatory repatriation tax¹." The Moores said this increased their 2017 tax bill by around $15,000. Their case weighed on whether the tax is unconstitutional, saying income must be realized before it's subject to taxation. 

In a 7-2 opinion, the Supreme Court found that the question at the core of the case was whether Congress could attribute and entity's realized and undistributed income to the entity's shareholders and partners, then require a tax on the shareholders or partners on the income attributed to them. The Court, looking at years of precedents, determined that the answer is "yes."

Learn more about foreign tax issues with Becker CPE

It's important to stay informed about further guidance or changes to Section 965. If you want to learn more about international and foreign tax, Becker has a wide selection of CPE courses that will help you build your knowledge! Check out the following tax CPE courses: 

• Introduction to the International Foreign Tax Credit
• Foreign Tax Credit and Foreign-Source Dividend Received Deduction
• Foreign Account Tax Compliance Act (FATCA)

Get these courses as well as over 700 on-demand CPE courses, 1,000 annual webcasts, and weekly podcasts with a Prime CPE subscription so you can build your knowledge in relevant topics, keep up with the latest tax changes, and meet your CPE requirements!