The Tax Cuts and Jobs Act (TCJA) of 2017 ushers in sweeping changes to how the United States taxes international business while preserving may of the concepts that exist under pre-TCJA law.
The act may be touted as a simplification for individuals. For the wage earner who reports almost all tax return items are reported to the IRS on a W-2, 1099, or 1098 for mortgage interest, that’s probably true.
From an international perspective, however, the US approach to taxing international operations just became significantly more complicated with the biggest change to tax law since the current offshore tax regime was enacted by the Kennedy Administration in 1962. Transition tax is just one of several fundamental changes in how the United States taxes international operations.
Historically, taxpayers could defer US taxation on offshore earnings of affiliated corporations subject to several anti-abuse regimes. The TCJA ushered in a dramatic change by allowing tax-free repatriations received by US corporations that have a 10% or greater stake in specified foreign corporations—and this is in addition to reducing the corporate tax rate to 21% from 35%.
For taxable years of deferred foreign income corporations (DFICs) beginning before January 1, 2018, all US taxpayers are required to calculate a transition tax on their offshore earnings and begin paying it to the Treasury as early as April 15, 2018.
Generally, most taxpayers can elect to pay the transition tax over eight years. And, for individual shareholders who holds his or her interests in DFICs through an S corporation, a potentially indefinite deferral exists until there is a so-called triggering event.
DFICs are specified foreign corporations with positive earnings and profit that haven’t been previously subject to US tax. This includes all foreign corporations where a US corporate shareholder has a 10% or greater interest.
There’s a small carve out in the definition of a specified foreign corporation when the US shareholder’s interest in a foreign corporation is subject to the passive foreign investment company or PFIC rules. In this situation, the PFIC rules trump the transition tax rules. Presumably, domestic corporation includes S corporations; however, guidance issued to date isn’t conclusive.
It’s important to note if a domestic corporation has a 10% or greater interest in a DFIC, then any other US shareholders (including individuals) holding a 10% or greater interest must also include the DFIC in its transition tax calculations. Congress expects a very high level of ownership transparency with this provision.
A calendar year-end taxpayer may elect to pay their transition tax over eight years. Assuming no acceleration events:
- 8% of the tax is due with each of the 2017–2021 tax returns
- 15% is due with the 2022 tax return
- 20% is due with 2023 tax return
- 25% is due with 2024 tax return
For taxpayers who extend, the transition tax is due with the extension. Transition tax under an installment election is accelerated with either of these events:
- Failure to timely pay any installment
- For business taxpayers, sale of substantially all operating assets, operations are wound up, or bankruptcy
In the case of a sale of operating assets, the buyer can elect to pay any remaining transition tax installments. This ability to transfer the remaining installments to the buyer will certainly factor into the deal value.
We anticipate further guidance will be issued addressing situations such as the death of an individual taxpayer who has made an installment election or the transfer of shares in foreign corporation by sale or gift.
Deferral Election for S Corporation Shareholders
In addition to an election to pay transition tax over eight years, S corporation shareholders have an alternative option. They may elect to defer payment of transition tax until there’s a triggering event.
Triggering events are as follows:
- The S corporation ceases to be an S corporation.
- There’s a liquidation or sale of substantially all of the S corporation’s assets.
- The S corporation goes out of existence.
- There’s a transfer of any of the S corporation’s shares by sale, reason of the shareholder’s death, or otherwise.
Once there’s a triggering event, the shareholder then has the opportunity to make the election to pay the transition tax over eight years, beginning in the year of the triggering event.
To summarize, S corporation shareholders have four options:
- Pay the whole transition tax by April 15, 2018
- Elect to spread the transition tax over eight installments
- Elect to defer payment of the transition tax until there’s a triggering event and then pay the full transition tax at that time
- Elect to defer payment of the transition tax until a triggering event occurs and then make an installment election to pay the transition tax over eight years
The election to defer transition tax is made on a shareholder-by-shareholder basis. Interestingly enough, when an S shareholder makes a deferral election, the S corporation becomes jointly and severally liable for the shareholder’s transition tax.
S corporations should review their shareholder agreements with respect to deferral elections before April 15, 2018, to establish some amount of corporate governance related to this joint and several liability. Shareholders who make this election could put the company at risk for payment of the transition tax caused by a shareholder’s malfeasance.
Transition Tax Amount
The new law is intended to make the tax imposed on deferred foreign income similar for all taxpayers. However, calculating the transition tax is a complex task.
In general, the amount of transition tax is a taxpayer’s share of untaxed and undistributed earnings accumulated since 1987 in every DFIC and multiplied by the appropriate tax rate. There are four, not-so-simple steps in this process.
Step one: Inventory the entities that must be analyzed.
- Related party rules must be considered to determine if the 10% ownership threshold is met.
- An individual is considered to own all the foreign stock owned by his or her spouse, children; and the family attribution rules extend to all grandparents and any number of great-grandparents or grand-children and their spouses.
- Partners own their share of any foreign corporations owned by their partnerships, and corporations own their share of any foreign subsidiaries no matter how far down the chain.
- Beneficiaries own their share of foreign corporations inside a trust.
- The attribution rules were expanded as well, so a fresh ownership analysis might be necessary in many situations.
Step two: Determine the amount of income (earnings and profit, or E&P) that’s subject to transition tax.
This isn’t as simple as looking at a foreign company’s financial statements and saying, for example, a particular shareholder owns 25% of the stock, therefore the shareholder’s E&P is 25% of retained earnings.
- E&P involves an annual analysis of the foreign company’s income, which is then converted to US generally accepted accounting principles (GAAP), and adjustments are made to convert US GAAP income to E&P using US tax principles.
- Corporate transactions, including sales of shares, redemptions, reorganization transactions, and payments of dividends, can all impact E&P.
- Special rules apply to loss companies.
- Some of the E&P may have been previously taxed in the United States under an anti-abuse regime.
Repeat this process for every DFIC identified in Step 1, taking the greater amount of E&P as of two measurement dates: November 2, 2017, and December 31, 2017.
Step three: Compute how much of the E&P relates to cash assets.
The act has two tax rates that apply for purposes of the transition tax:
- A higher rate applicable to E&P supported by a DFIC’s cash assets
- A lower rate applicable to noncash assets
Cash assets include: cash, net accounts receivable, near cash assets, the fair market value of publicly traded securities, foreign currency, short term obligations, and anything else placed in the cash asset category by regulations or IRS guidance.
This computation is done using the greater of two amounts. The first is based on the DFIC’s last tax year ending before 2018 and the other is based on an average cash position for the prior two year-ends. The E&P ascribed to the lower taxed, noncash assets is the excess of any E&P over the balance of cash assets.
Put another way, the lower transition tax rate is a residual category and, depending on the circumstances, may not apply. Unlike E&P, the cash assets computation is determined on an aggregate basis using the DFICs’ year-ends.
Step four: Calculate the transition tax.
This is where the law gets even more complex. Congress didn’t make this is as simple as applying a rate to the amounts determined in step three. Ultimately the transition tax rates depend on whether the taxpayer is a corporation or any other type of taxpayer. The discussion below is limited to corporations and individuals.
Corporations are supposed to pay 15.5% transition tax on E&P related to cash assets and 8% transition tax on the rest of the E&P. However, the rules were written such that the full amount of E&P under step two is included, but then a subtraction amount is calculated in order to bring the effective tax rate back down to the 15.5% and 8% rates.
This subtraction amount is computed in reference to the tax rate for corporations, which is as high as 35%. There’s a limited ability to claim foreign tax credits against the transition tax.
Individuals have to go through this with and without computation and are entitled to somewhat lower subtractions.
For individuals in the highest 2017 tax bracket (39.6%), E&P attributable to cash assets will be subject to transition tax at approximately 17.5%, excluding the net investment income tax; and E&P attributable to noncash assets will be subject to transition tax at approximately 9.1%.
There’s an election for individuals to be treated as corporate shareholders for purposes of the transition tax. This would be another step, and the election should be considered when it will cause the transition tax liability to be a lower amount. However, the overall effects of this election need to be evaluated as there may be other ancillary effects.
Documentation and Record Keeping
Depending on a taxpayer’s particular set of facts, the complexity of the documentation will vary. Regardless of how organized you might be, this could be a time consuming and painful process.
The stakes are high though. In addition to penalties, the statute of limitations for all things related to transition tax is six years. For S corporation shareholders making a deferral election, the statute is held open for six years beyond the last installment of the transition tax.
Gathering the information and working through the computations will take time, so there’s value in starting early. There are a number of key elements to document for purposes of the transition tax.
Four Must-Have Documents
- An inventory of entities subject to the transition tax
- A calculation of the E&P subject to the transition tax
- A calculation of how much E&P relates to cash assets taxed at the higher transition tax rate and how much relates to noncash assets taxed at lower transition tax rates
- Substantiation of the creditable foreign taxes for taxpayers who may be eligible to claim a foreign tax credit with respect to the transition tax
Watch for Guidance
The IRS is starting to publish guidance that will need to be considered. Come up with a game plan. Transition tax computations will need to be integrated with your tax return but may require special resources. Work with your international tax professionals to get educated and establish timelines and expectations.
We’re Here to Help
We’ll continue to inform you as we learn of additional guidance. If you’d like to learn more about how your international business is affected by this historical change in tax law, contact your Moss Adams professional. You can also visit our dedicated tax reform webpage