This information is based on the statutes and guidance available as of the date of publication and is subject to change. 

Perhaps one of the most significant items in the 2017 Tax Cuts and Jobs Act, the repatriation toll tax under IRC §965 has been touted as the mechanism by which the U.S. will move to a modified territorial system of taxation. One significant change to the attribution rules will result in many more taxpayers being subject to this one-time tax than previously anticipated. Because the tax applies in 2017, individuals and corporations will need to understand the impact on cash flows and financial statements. In order to evaluate this impact, every structure in which a U.S. corporation or a U.S. individual has direct or indirect ownership of a foreign corporation anywhere in the structure should be reviewed immediately.

Who is Subject to the Tax?

A U.S. shareholder (corporate or individual) of a deferred foreign income corporation is subject to the repatriation toll tax in 2017. A deferred foreign income corporation is any specified foreign corporation that has accumulated post-1986 deferred foreign income greater than zero as of November 2, 2017 or December 31, 2017.

The term specified foreign corporation (“SFC”) includes:

  • A controlled foreign corporation (“CFC”) and
  • A foreign corporation in which a U.S. corporation owns 10% or more of voting power

A CFC is any foreign corporation if more than 50% of the total combined voting power of all classes of stock of such corporation entitled to vote is owned directly, indirectly or constructively by U.S. shareholders for at least 30 days during the taxable year.

For tax years after 12/31/17, the definition of a U.S. shareholder has been expanded to any U.S. person owning 10% or more of the combined voting power of all classes of stock or 10% or more of the value of the shares of all classes of stock. In addition, the definition of a CFC has been expanded to change the 30 day holding requirement to any day during the taxable year. Although these changes will not impact the repatriation tax calculation, it will impact the determination of a CFC in future years.

Background on Accelerated Taxation of Income of Foreign Corporations (“Subpart F”)

A U.S. shareholder of a foreign corporation is generally not subject to U.S. tax on the foreign income of such corporation until the income is distributed as a dividend to the shareholder. However, a U.S. shareholder must include in taxable income its pro rata share of a CFC’s Subpart F income, whether or not such income is actually distributed during the year. This results in the current taxation of certain income of CFCs to U.S. shareholders.

Under the new repatriation tax provisions, the Subpart F income of a deferred foreign income corporation is increased by the greater of the foreign corporation’s accumulated post-1986 deferred foreign income determined as of November 2, 2017 or the foreign corporation’s accumulated post-1986 deferred foreign income determined as of December 31, 2017. The increased Subpart F income must be recognized in tax year 2017.

This means that a U.S. shareholder of a deferred foreign income corporation must pick up additional taxable income on its 2017 tax return for its pro rata share of the accumulated post-1986 earnings and profits (the “mandatory inclusion amount”).

Earnings Subject to Tax 

Accumulated post-1986 deferred foreign income subject to tax equals the corporation’s accumulated post-1986 Earnings & Profits (“E&P”) for the periods in which the corporation was a specified foreign corporation. E&P is excluded to the extent such earnings were treated as income effectively connected with a U.S. trade or business or is considered previously taxed income (“PTI”).

When determining E&P for purposes of the income inclusion, adjustments may be required to the extent that there were intercompany distributions during 2017.

The new law provides a mechanism to allow E&P deficits to offset positive earnings, however this is not necessarily an equal offset. In addition, adjustments may be required for deductible payments between SFCs occurring between November 2, 2017 and December 31, 2017. 

It is important to note that the shareholder’s mandatory inclusion amount for repatriation tax purposes is based on the greater of the foreign corporation’s E&P determined as of November 2, 2017 or December 31, 2017. The actual tax calculation, however, looks at the corporation’s cash position on multiple dates. 

How the Tax is Calculated

Although the mechanics of the calculation are convoluted, the ultimate effect is to tax accumulated E&P attributable to liquid assets such as cash (the “aggregate foreign cash position”) at a rate of 15.5% and to tax accumulated E&P attributable to illiquid assets at a rate of 8%.

A calendar year foreign corporation’s aggregate foreign cash position must be evaluated as of December 31, 2017, December 31, 2016 and December 31, 2015. Specifically, the cash position is the greater of the cash position as of December 31, 2017 or 50% of the sum of the cash position on December 31, 2016 and December 31, 2015. 

The aggregate foreign cash position includes:

  • Cash held by the foreign corporation
  • The net accounts receivable (excess of accounts receivable over accounts payable but not less than zero) of the foreign corporation plus
  • The fair market value of the following assets held by the foreign corporation:
    • Personal property which is of a type that is actively traded and for which there is an established market
    • Commercial paper, certificates of deposit, securities of the federal government and securities of any state or foreign government
    • Any foreign currency
    • Any obligation with a term of less than one year
    • Any asset which the Secretary identifies as being economically equivalent to the above assets. Currently, Notice 2018-7 provides that cash will include the fair market value of each derivative financial instrument that is not a bona fide hedging transaction.

Example

Assume that A is a U.S. shareholder and A owns 100% of foreign corporation F. F is a controlled foreign corporation (“CFC”). The Assets section of F’s balance sheet as of December 31, 2017 is as follows:

For simplicity purposes, we have used the 12/31/17 cash balance in this example. However, cash must be evaluated at multiple dates as indicated above.

Assume CFC F had accumulated post-1986 non-previously taxed E&P of $6,200 on November 2, 2017 and $5,800 on December 31, 2017. E&P determined as of November 2, 2017 is used for this calculation since it is greater than E&P determined as of December 31, 2017.

A’s repatriation toll tax is calculated as follows:

Note that the gross Mandatory Inclusion Amount “A,” as opposed to the Net Income Inclusion “C,” will be considered previously taxed income going forward.

This is because the mandatory inclusion amount is considered a Subpart F income inclusion. 

Because the statutory language of the law requires the gross-up to be calculated at the maximum corporate tax rate, yet individual taxpayers must apply their marginal tax rate to determine the actual repatriation tax, individuals in tax brackets above 35% are especially disadvantaged by these rules.

Paying the Tax

Corporations may offset the repatriation tax with a deemed-paid foreign tax credit; however, individuals may not do so unless they make an election to be taxed as a corporation under IRC §962. We can assist you with evaluating the potential benefit of making this election.

U.S. shareholders (corporate and individual) subject to the tax may elect to pay the net tax liability in unequal installments over 8 years, beginning with the due date of the 2017 tax return (without extensions).

New Attribution Rules

There have been significant changes to the attribution rules and now certain corporations which were not previously considered CFCs will be CFCs. Consider the following common example below:

In the above example, I would have a §965 mandatory repatriation tax income inclusion, potentially a §951(a) Subpart F inclusion, and a Category 5 Form 5471 filing requirement. 

The attribution rules are incredibly complex and need to be evaluated on case-by-case basis.

Key Takeaways / Action Items

  • Specified foreign corporations must determine their accumulated post-1986 E&P for the periods in which the corporation was a specified foreign corporation.
  • U.S. corporations that are subject to the repatriation tax must accrue for such tax in their 2017 financial statements.
  • Individual shareholders subject to the repatriation tax should evaluate whether an IRC §962 election should be made and should be prepared to have adequate cash to pay the tax.
  • In order to evaluate this impact, every structure in which a U.S. corporation or a U.S. individual owns (directly or indirectly) 10% or more of a foreign corporation anywhere in the structure should be reviewed immediately.