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Transition Tax Proposed Regulations

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On August 1, 2018, the Treasury Department and Internal Revenue Service (the "IRS") released proposed regulations (the "Proposed Regulations" available here) under Section 965 of the Internal Revenue Code, which was created by the recent tax legislation (commonly known as the Tax Cuts and Jobs Act (the "TCJA")) and generally requires a U.S. shareholder (which for this purpose generally includes U.S. corporations, partnerships, trusts, estates, and individuals that own 10% of the voting power) to pay a transition tax on the earnings of a deferred foreign income corporation ("DFIC") as if such earnings had been repatriated to the United States. Congress left many questions about the applicability of Section 965 unanswered and granted the Treasury Department and the IRS broad authority to promulgate regulations to carry out the provisions in Section 965, including anti-avoidance measures.

While the Proposed Regulations and accompanying preamble are lengthy and dense, they generally provide the following:

  • A detailed set of general rules and definitions (including a limited exception to downward attribution of stock ownership from a partner to a partnership), along with a lengthy series of illustrative examples;
  • Rules setting forth adjustments to earnings and profits of a DFIC, limiting the amount of gain recognized upon the distribution of earnings and profits previously taxed under Section 965 and adjusting a U.S. shareholder's tax basis in DFIC stock;
  • Rules pertaining to the calculation of the DFIC's aggregate foreign cash position, including a rule disregarding certain intercompany obligations between related corporations and other rules to prevent double counting of assets;
  • Anti-avoidance rules that disregard certain transactions undertaken with a principal purpose of reducing the Section 965 tax liability and certain changes of methods of accounting and entity classification elections (regardless of the principal purpose of the change), as well as certain transactions that occurred between the two earnings and profits measurement dates;
  • Coordination with the foreign tax credit provisions in effect prior to repeal or amendment by the TCJA;
  • Rules pertaining to and mechanisms for making various elections allowed under Section 965: the Section 965(h) election to pay the Section 965 tax liability in installments; the Section 965(i) election for S corporation shareholders for deferral of the tax liability; the Section 965(m) election for installment payments for real estate investment trusts; the Section 965(n) election not to apply a net operating loss; and a regulatory election to use an alternative method of calculating post-1986 accumulated earnings and profits; and
  • Various rules applying Section 965 and the Proposed Regulations to U.S. shareholders that are members of a consolidated group.

When finalized, the Proposed Regulations will be effective as of the beginning of the last taxable year of a foreign corporation that begins before January 1, 2018, or with respect to a U.S. person, the beginning of the taxable year in which or with which such taxable year of the foreign corporation ends (with a clarification that the anti-avoidance rules apply regardless of whether the avoidance transaction, method of accounting change, entity classification election or specified payment occurred or had an effective date prior to such date).

The Proposed Regulations, however, leave unresolved various significant issues. For instance, with respect to the repeal of Section 958(b)(4), which prior to repeal prevented downward attribution of stock ownership from a foreign person to a U.S. person, the Treasury Department and the IRS simply stated that the issue was beyond the scope of the Proposed Regulations. Similarly, the preamble notes that the Treasury Department and the IRS considered and rejected comments requesting a carve-out for blocked foreign income (i.e., earnings that cannot be repatriated due to exchange controls or other foreign legal restrictions) from the earnings and profits subject to Section 965.

Taxpayers wishing to submit comments or request a public hearing on the Proposed Regulations must do so within 60 days after the Proposed Regulations are published in the Federal Register.

Should you have any questions or concerns about the impact the Proposed Regulations may have on your business, please contact any of the authors of this update.

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