Before the Tax Cuts and Jobs Act (TCJA), the U.S. employed a worldwide tax system, under which U.S. persons were generally taxed on all income, whether derived in the U.S. or abroad. Foreign income earned by U.S. shareholders through foreign corporations was generally subject to U.S. tax only when the income was distributed as a dividend to the U.S. shareholder.
The TCJA’s new IRC § 965 fundamentally changes these general rules. It now requires the current year (2017) taxation of foreign income of a deferred foreign income corporation. A deferred foreign income corporation includes any Controlled Foreign Corporation (CFC), and a CFC is any foreign corporation with more than 50% ownership by U.S. shareholders.
Under the historic Subpart F rules, though, U.S. shareholders of a CFC were previously required to include in income their pro rata share of the corporation’s Subpart F income, whether or not the income was distributed to the shareholders. For Subpart F income purposes, a U.S. shareholder is a U.S. person who is a 10% owner of a foreign corporation.
Under the new IRC § 965, in the last tax year of a deferred foreign income corporation that begins before Jan. 1, 2018, the Subpart F income of the foreign corporation (income currently required to be reported by U.S. shareholders) is increased by its accumulated post-1986 earnings and profits (E&P). E&P, while a defined tax term, is closely related to retained earnings under GAAP terms with certain tax accounting adjustments – most notably tax depreciation.
Thus, U.S. shareholders (including individuals, partnerships and LLCs) in a foreign corporation must include in income their pro rata share of the undistributed, non-previously-taxed post-1986 foreign earnings and profits of the corporation in the last tax year, which begins before Jan. 1, 2018. Because of this, U.S. taxpayers that own an interest in a foreign corporation may have a surprise increase in their tax bill for 2017.
The portion of the E&P comprising cash or cash equivalents is taxed at a rate of 15.5%, while any remaining E&P is taxed at a reduced rate of 8%.
At the election of the U.S. shareholder, the tax liability is payable over a period of up to eight years. The payments for each of the first five years equals 8% of the net tax liability. The amount of the sixth installment is 15% of the net tax liability, increasing to 20% for the seventh installment and the remaining balance of 25% in the eighth year.
The TCJA provides a special rule for S corporations. Their shareholders can elect to maintain deferral on such foreign income until the S corporation changes its status, sells substantially all its assets, ceases to conduct business, or the electing shareholder transfers its S corporation stock.
Additionally, corporate U.S. shareholders may be able to reduce this tax liability through the deemed-paid foreign tax credit (FTC), or avail themselves of a deduction for a portion of the mandatory inclusion.
The post-1986 E&P taken into consideration in computing the mandatory inclusion generally is reduced by any other accumulated foreign E&P deficits that are properly allocated to the U.S. shareholder. In other words, the accumulated earnings and profits of all CFCs (including accumulated deficits) is aggregated before calculating the tax.
In general, shareholders subject to this tax will have been filing Form 5471 with their U.S. tax return every year. Form 5471 identifies CFCs, foreign earnings and profits, and presents balance sheet numbers for the foreign corporation. Any tax return that contains a Form 5471 identifies a taxpayer who is potentially subject to the new deemed repatriation tax.
For each of these shareholders whose tax return we prepare, we will have to make a calculation of accumulated post-1986 earnings and profits from all controlled foreign corporations and determine whether the earnings are held in cash or other assets in order to calculate the new deemed repatriation tax.
The TCJA is the largest overhaul of the tax code in more than 30 years, and we’ve covered only the highlights of the international tax provisions here. Please contact your CSH advisor if you have questions about how this may affect you or your business.