Code Section 965 of the Tax Cuts and Jobs Act requires some US shareholders to pay a one-time transition tax on the untaxed foreign earnings of certain specified foreign corporation (“SFC”) as if those earnings had been repatriated to the US. Very generally, section 965 of the Code allows taxpayers to reduce the amount of such inclusion based on deficits in earnings and profits with respect to other SFCs.
On January 15, 2019, the final regulations of the transition tax under Section 965 were released. The final regulations are fundamentally the same as the proposed regulations (with some modifications) and apply to the last taxable year of a specified foreign corporation (“SFC”) beginning before January 1, 2018 with respect to a US shareholder. For 2017 calendar year SFCs, the transition tax is calculated in 2017, and for fiscal year SFCs ending in 2018, the transition tax applies to the 2018 tax year.
It is important to note the anti-abuse provisions of the transition tax, which also remain similar to the proposed regulations, with some modifications. Under the anti-abuse provisions, a transaction is disregarded when determining the “section 965 element” if each of the following conditions are met:
- Any part of the transaction occurs on or after November 2, 2017;
- The purpose of the transaction is to change the amount of a “section 965 element” of the US shareholder; and
- The transaction, in fact, changes the amount of the section “965 element” of the US shareholder.
The final regulations define “section 965 element” as any of the following amounts:
- The US shareholder’s section 965(a) inclusion (i.e. reduces earnings or increases a deficit) amount with respect to the SFC;
- The aggregate foreign cash position (i.e. reduction to cash position) of the US shareholder; or
- The amount of the foreign income taxes (i.e. increase in foreign taxes paid) of a SFC deemed paid by the US shareholder under the provisions of Sec. 960 as result of the section 965(a) inclusion. The deemed foreign tax credit is only available to US corporate shareholders that own at least 10% of a SFC and is not applicable to individual US shareholders.
According to the regulations, the transactions that may change the “section 965 element” include accounting methods, entity classification elections, specified payment and double counting rule, and certain cash reduction transactions.
Due to higher Canadian tax rates, one option is for individual US shareholders to create excess foreign tax credits in the year after the transition tax year that are sufficient enough to carryback to the previous year and offset the transition tax. For US tax purposes, a foreign tax credit for Canadian taxes paid can be carried back one year.
For example, a significant bonus can be paid in 2018 for a 2017 transition tax year (or 2019 for a 2018 transition tax year for fiscal year SFCs), a dividend distribution can be taken, or some combination of both. However, any Canadian tax paid on a dividend distribution to reduce previously taxed income (i.e. income inclusion for transition tax purposes) is subject to a reduction in foreign tax credits that is equal to the ratio of the participation exemption deducted against total earnings and profits subject to transition tax. The participation exemption is the amount of exclusion that is applied against the earnings and profits.
It is not clear if the payment of a salary would also be subject to a reduction in foreign tax credits if it reduces pre-taxed cumulative earnings and profits.
In summary, we believe that increasing the foreign tax credit for carryback to recoup the transition tax is not within the scope of the anti-abuse provisions of the regulations.