Treasury Issues Additional Guidance Under Section 965

Summary
On April 2, 2018, the Department of the Treasury and the Internal Revenue Service (collectively, “Treasury”) issued Notice 2018-26 (the “Notice”). The Notice provides additional guidance under Section 965. For prior guidance issued under Section 965, see Notice 2018-07, Notice 2018-13, and Rev. Proc. 2018-17.

Details
In general, Section 965(a) provides that for the last taxable year of a deferred foreign income corporation (“DFIC”) that begins before January 1, 2018 (such year of the DFIC, the “inclusion year”), the subpart F income of the corporation (as otherwise determined for such taxable year under Section 952) shall be increased by the greater of (1) the accumulated post-1986 deferred foreign income of such corporation determined as of November 2, 2017, or (2) the accumulated post-1986 deferred foreign income of such corporation determined as of December 31, 2017 (each such date, a “measurement date,” and the greater of the accumulated post-1986 deferred foreign income of the corporation as of the measurement dates, the “Section 965(a) earnings amount”).

Section 3 of the Notice
Section 3 of the Notice includes the following regulations to be issued addressing the application of Section 965.

1. Application of Section 318(a)(3)(A) to Treat a Foreign Corporation as a Specified Foreign Corporation
The Notice provides that Treasury intends to issue regulations providing that, solely for purposes of determining whether a foreign corporation is a specified foreign corporation within the meaning of Section 965(e)(1)(B), stock owned, directly or indirectly, by or for a partner (tested partner) will not be considered as being owned by a partnership under Sections 958(b) and 318(a)(3)(A) if such partner owns less than five percent of the interests in the partnership’s capital and profits. In applying this rule, an interest in the partnership owned by another partner will be considered as being owned by the tested partner under the principles of Sections 958(b) and 318, as modified by the Notice, as if the interest in the partnership were stock. See the examples in Section 3.01 of the Notice for an illustration of these rules.

2. Determination of Cash Measurement Dates of a Specified Foreign Corporation with Respect to a U.S. Shareholder
For purposes of determining cash measurement dates the Notice provides that Treasury intends to issue regulations providing that:
• The final cash measurement date of a specified foreign corporation is the close of the last taxable year of the specified foreign corporation that begins before January 1, 2018, and ends on or after November 2, 2017, if any;
• The second cash measurement date of a specified foreign corporation is the close of the last taxable year of the specified foreign corporation that ends after November 1, 2016 and before November 2, 2017, if any;
• The first cash measurement date of a specified foreign corporation is the close of the last taxable year of the specified foreign corporation that ends after November 1, 2015, and before November 2, 2016 if any; and
• A U.S. shareholder takes into account its pro rata share of the cash position of a specified foreign corporation as of any cash measurement date of the specified foreign corporation on which such U.S. shareholder is a U.S. shareholder of such specified foreign corporation, regardless of whether such U.S. shareholder is a U.S. shareholder of such specified foreign corporation as of any other cash measurement date, including the final cash measurement date of such specified foreign corporation.

See the Example in section 3.02 of the Notice for an illustration of these rules.
The Notice also states that for purposes of applying these rules, a 52-53 week taxable year is deemed to begin on the first day of the calendar month nearest to the first day of the 52-53 week taxable year, and is deemed to end or close on the last day of the calendar month nearest to the last day of the 52-53 week taxable year, as the case may be.

3. Treatment of Certain Accrued Foreign Income Taxes for Purposes of Determining Post-1986 Earnings and Profits
The Notice provides that Treasury intends to issue regulations providing that, for purposes of determining a specified foreign corporation’s post-1986 earnings and profits as of the measurement date on November 2, 2017, any foreign income tax (as defined in Section 901(m)(5)) that accrues (i) within the specified foreign corporation’s U.S. taxable year that includes November 2, 2017, and (ii) after November 2, 2017, but on or before December 31, 2017, will be allocated between the respective portions of the foreign tax base on which the accrued foreign taxes are determined that are attributable to the part of the U.S. taxable year ending on November 2, 2017, and part of the U.S. taxable year beginning after November 2, 2017.

The Notice also states that Treasury has determined that it is appropriate to limit the scope of the regulations to foreign income taxes that accrue on or before December 31, 2017, to allow for the Section 965(a) earnings amounts of each specified foreign corporation to be determined as of the final measurement date, December 31, 2017. The Notice also states the regulations detailed in this section are relevant solely for purposes of determining a specified foreign corporation’s earnings and profits (including a deficit) within the meaning of Section 965(d)(3) and the regulations to be issued will not affect the computation of credits for taxes deemed paid under Sections 902 and 960.

4. Prevention of the Reduction of the Section 965 Tax Liability of a U.S. Shareholder
The Notice contains a number of anti-avoidance rules designed to address taxpayers that try to reduce their Section 965 tax liability.

a. Anti-Avoidance Rule

The Notice provides that Treasury intends to issue regulations providing that a transaction will be disregarded for purposes of determining a U.S. shareholder’s Section 965 tax liability if each of the following conditions is satisfied:
• Such transaction occurs, in whole or in part, on or after November 2, 2017 (the “specified date”);
• Such transaction is undertaken with a principal purpose of reducing the Section 965 tax liability of such U.S. shareholder; and
• Such transaction would, without regard to this sentence, reduce the Section 965 tax liability of such U.S. shareholder (the “anti-avoidance rule”).
For purposes of section 3.04(a) and section 3.04(b) of the Notice, the Notice states that a transaction (or change in method of accounting or election described in section 3.04(b) of the Notice) reduces the Section 965 tax liability of a U.S. shareholder if such transaction:
• Reduces a Section 965(a) inclusion amount of such U.S. shareholder with respect to any such specified foreign corporation;
• Reduces the aggregate foreign cash position of such U.S. shareholder; or
• Increases the amount of foreign income taxes of any specified foreign corporation deemed paid by such U.S. shareholder under Section 960 as a result of an inclusion under Section 951(a) by reason of Section 965.
Also, the Notice provides that for purposes of section 3.04(a) and section 3.04(b) of the Notice, in the case of a U.S. shareholder that is a domestic pass-through entity, a domestic pass-through owner of such domestic pass-through entity is also treated as a U.S. shareholder.

The Notice includes various rules relating to the application of the anti-avoidance rule to “cash reduction transactions,” “E&P reduction transactions,” and “pro rata share transactions.”

b. Disregard of Certain Changes in Method of Accounting and Entity Classification Elections

The Notice provides that Treasury intends to issue regulations providing that any change in method of accounting made for a taxable year of a specified foreign corporation that ends in 2017 or 2018 will be disregarded for purposes of determining the Section 965 tax liability of a U.S. shareholder if such change in method of accounting would otherwise reduce the Section 965 tax liability of such U.S. shareholder. This rule will apply regardless of whether such change in method of accounting was made in accordance with the procedures described in Rev. Proc. 2015-13 (or successor), and whether such change in method of accounting was properly made. The Notice states that these regulations will not apply to a change in method of accounting for which the original and/or duplicate copy of any Form 3115, Application for Change in Accounting Method, requesting the change was filed before the specified date, November 2, 2017.

Additionally, the Notice further indicates that regulations will provide that any entity classification election under §301.7701-3 that is filed on or after the specified date will be disregarded for purposes of determining the Section 965 tax liability of such U.S. shareholder if such entity classification election would otherwise reduce the Section 965 tax liability of any U.S. shareholder. An entity classification election filed on or after the specified date will be subject to these regulations even if such entity classification election was effective on a date before the specified date.

Importantly, these regulations will apply regardless of whether such change in method of accounting or change of entity classification election is made with a principal purpose of reducing the Section 965 tax liability of a U.S. shareholder.

5. Rules Related to Elections, Reporting, and Payment

a. Documentation of Cash Position

The Notice provides that the IRS plans to issue forms, publications, regulations or other guidance that will specify the documentation that a U.S. shareholder must maintain or provide, and the time and manner for providing any such documentation, to make the required demonstration to the Secretary as required under Section 965(c)(3)(D).

b. U.S. Persons Eligible to Make Elections Under Section 965 in the Case of a U.S. Shareholder that is a Domestic Pass-Through Entity

The Notice provides that Treasury intends to issue regulations that will provide that in the case of a domestic pass-through entity that is a U.S. shareholder, each domestic pass-through owner takes into account its share of the Section 965(a) inclusion amount with respect to Section 958(a) stock of a DFIC of the domestic pass-through entity and the Section 965(c) deduction with respect to such amount, regardless of whether such domestic pass-through owner is also a U.S. shareholder with respect to such DFIC. In such case, the Section 965(a) inclusion amount and the related Section 965(c) deduction must be allocated in the same proportion.

The Notice further provides that Treasury intends to issue regulations allowing domestic pass-through owners to make an election under Section 965(h), Election to pay liability in installments, 965(m), Special rules for U.S. shareholders which are real estate investment trusts, and 965(n), Election to not apply net operating loss deduction (“specified elections”) that applies to its share of the Section 965(a) inclusion amount with respect to Section 958(a) stock of a DFIC of the domestic pass-through entity. Treasury addressed an open issue as it relates to these elections by providing that a domestic pass-through owner will be permitted to make a specified election mentioned above regardless of whether the domestic pass-through owner is itself a U.S. shareholder of the DFIC. If a domestic pass-through owner makes a specified election for its taxable year, the Notice requires that such election will be applicable to all Section 965(a) inclusion amounts included in the gross income of such domestic pass-through owner for such taxable year (other than amounts with respect to which elections under Section 965(i) are effective) whether included directly by reason of owning Section 958(a) stock in a DFIC or indirectly by reason of being a domestic pass-through owner.

Also, the Notice states that if an S corporation, is directly or indirectly, a partner, beneficiary, or owner of a domestic pass-through entity and takes into account a share of the Section 965(a) inclusion amount of a domestic pass-through entity with respect to a DFIC, and the S corporation is a U.S. shareholder of the DFIC, the regulations will permit shareholders of the S corporation to make an election under Section 965(i) to defer the shareholder’s net tax liability under Section 965 with respect to the S corporation. However, if the S corporation is not itself of a U.S. shareholder of a DFIC, the Notice indicates that the net tax liability under Section 965 of a shareholder with respect to the S corporation for purposes of the election under Section 965(i) will not include the shareholder’s share of the domestic pass-through entity’s Section 965(a) inclusion amount with respect to the DFIC or Section 965(c) deduction with respect to such amount.

c. Determination of Amount of Net Tax Liability Under Section 965 for Purposes of Section 965(h)

The Notice provides that Treasury intends to issue regulations providing that for purposes of determining the net tax liability under Section 965 of a domestic pass-through owner, the domestic pass-through owner will be treated as a U.S. shareholder. See, however, section 5 of the Notice and discussion in Section II. Other Sections of the Notice below, which provides that a domestic pass-through owner that is not itself a U.S. shareholder is not permitted to make an election under Section 962.

The Notice further provides that the regulations will provide that, in the case of a taxpayer that has made one or more elections under Section 965(i) for a taxable year, the taxpayer’s net tax liability under Section 965 for purposes of Section 965(h) is the taxpayer’s net tax liability under Section 965 as determined under Section 965(h)(6) (taking into account the rules in section 3.05(c) of the Notice) reduced by the aggregate amount of the taxpayer’s net tax liabilities under Section 965 as determined under Section 965(i)(3) (taking into account the rule provided in section 3.05(b) of the Notice) with respect to which elections under Section 965(i) are effective.

d. Application of Section 965(n) to Losses Arising in the Year in Which the Inclusion Year of a DFIC Ends

The Notice provides that Treasury intends to issue regulations providing that, if an election under Section 965(n) is made with respect to a taxable year in which or with which the inclusion year of a DFIC ends, the amount of a net operating loss for such taxable year will be determined without taking into account as gross income the amount described in Section 965(n)(2). The Notice also states that the regulations will also clarify that an election made under Section 965(n) will be treated as made with respect to both the amount of a net operating loss for such taxable year and the net operating loss carryovers or carrybacks for such taxable year.

e. Filing and Payment Due Date for Specified Individuals

The Notice provides that Treasury intends to issue regulations providing that if a specified individual (i.e., U.S. citizens or residents whose tax homes and abodes, in a real and substantial sense, are outside the United States and Puerto Rico, and U.S. citizens and residents in military or naval service on duty, including non-permanent or short term duty outside the United States and Puerto Rico) receives an extension of time to file and pay under §1.6081-5(a)(5) or (6), then the individual’s due date for an installment under Section 965(h) is also the fifteenth day of the sixth month following the close of a taxable year.

6. Treatment of Section 965(c) Deduction for Purposes of Sections 62(a) and 63(d)
The Notice provides that Treasury intends to issue regulations providing that a Section 965(c) deduction will not be treated as an itemized deduction, including for purposes of Sections 56 and 67 so that the Section 965(c) deduction will not be subject to the 2-percent floor under Section 67 or the deduction disallowance under the AMT, or in the case of a taxable year beginning after December 31, 2017, the deduction disallowance under Section 67 as modified by the Tax Cuts and Jobs Act.

Other Sections of the Notice
1. Section 4 of the Notice
Section 4 of the Notice modifies the rule described in section 3.04(a) of Notice 2018-13 and provides that Treasury intends to issue regulations providing that the terms “accounts receivable” and “accounts payable” will include only receivables or payables with a term of less than one year.

2. Section 5 of the Notice – Section 962 Elections
Section 5 of the Notice addresses Section 962 elections. The Notice states that Treasury intends to issue regulations clarifying that a domestic pass-through owner who is an individual (including, as provided in §1.962-2(a), a trust or estate) and a U.S. shareholder with respect to a DFIC may make an election under Section 962 with respect to the individual’s share of the Section 965(a) inclusion amount of a domestic pass-through entity with respect to such DFIC. However, an individual who is not a U.S. shareholder of a DFIC is not permitted to make an election under Section 962 with respect to the individual’s share of a Section 965(a) inclusion amount of a domestic pass-through entity with respect to such DFIC notwithstanding the rules in section 3.05(b) and (c) of the Notice. The Notice provides that the regulations will clarify the same principles apply to inclusions under Section 951(a) other than by reason of Section 965.

Section 5 of the Notice also provides that Treasury intends to modify §1.962-1(b)(1)(i) to provide that, in computing the amount of tax due as a result of a Section 962 election, the Section 965(c) deduction may be taken into account. Specifically, the regulations will provide that “taxable income” as used in Section 11 shall be reduced by the Section 965(c) deduction. The Notice further provides that these regulations will not apply to any other deductions, and therefore existing §1.962-1(b)(1)(i) will continue to provide that “taxable income” as used in Section 11 shall not be reduced by any other deductions. Any Section 965(c) deduction allowed in determining “taxable income” as used in Section 11 for purposes of computing the tax due as a result of a Section 962 election will not also be allowed for purposes of determining an individual’s actual taxable income. See the Example in section 5 of the Notice for additional details.

3. Section 6 of the Notice
Section 6 of the Notice provides certain penalty waivers with respect to Section 965. In particular, the Notice provides that the IRS will waive underpayment penalties under Sections 6654 and 6655 with respect to a taxpayer’s net tax liability under Section 965 for those taxpayers that make an election under Section 965(h). In addition, the Notice states that the IRS will waive underpayment penalties under Sections 6654 and 6655 with respect to a taxpayer’s net tax liability under Section 965 for those taxpayers who do not elect to pay their net tax liability under Section 965 in installments. Accordingly, a taxpayer’s required installments of estimated tax need not include amounts attributable to its net tax liability under Section 965 to prevent the imposition of penalties under Sections 6654(a) and 6655(a). The Notice further provides that, if a taxpayer fails to timely pay its net tax liability under Section 965 when due, other Sections of the Code may apply; for example, additions to tax could result under Section 6651, and installment payments could be accelerated under Section 965(h)(3). The Notice also provides that the instructions to estimated tax forms will be modified, as necessary to clarify that no underpayment penalty will be imposed under Section 6654 or Section 6655 with respect to a taxpayer’s net tax liability under Section 965 and that the taxpayer may exclude such amounts when calculating the amount of its required installment.

Section 6 of the Notice further provides that if the amendment to Section 965 or the amendment to Section 958(b) by the Tax Cuts and Jobs Act causes an underpayment related to a required installment of estimated tax due on or before January 15, 2018, the estimated tax penalty under Section 6654 or Section 6655 will not apply to that underpayment.

Effective Dates
Section 965 is effective for the last taxable years of foreign corporations that begin before January 1, 2018, and with respect to U.S. shareholders, for the taxable years in which or with which such taxable years of the foreign corporations end. The Notice provides that Treasury intends to provide that the regulations and instructions described in sections 3, 4, 5 and 6 of the Notice are effective beginning for the first taxable year of a foreign corporation (and with respect to U.S. shareholders, the taxable years in which or with which such taxable years of the foreign corporations ends) to which Section 965 applies. Before the issuance of the regulations and instructions described in the Notice, the Notice permits taxpayers to rely on the rules described in sections 3, 4, 5 and 6 of the Notice.

The Notice also clarifies that taxpayers may rely on section 5.01 of Notice 2018-13 with respect to the last taxable year of foreign corporations beginning before January 1, 2018, and each subsequent year of such foreign corporations, and for the taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end, pending the issuance of further guidance (the application of which will be prospective).

Insights
We can assist our clients with calculating their income tax liability under Section 965 and help with understanding the various aspects related to Section 965, including the rules discussed in the Notice.