Among the many changes to the tax code introduced by the Tax Cuts and Jobs Act, one of the most complex involved the revision of Code Section 965. In brief, Section 965 as amended, requires U.S. shareholders of certain specified foreign corporations to pay a transition tax on untaxed foreign earnings as if those earnings had been repatriated to the U.S. This income inclusion is required to be reported on the U.S. shareholder’s return for the last tax year of the business beginning before January 1, 2018 – for many taxpayers this meant that the Section 965 income inclusion was to be reported on its December 31, 2017 tax return. Taxpayers may elect to pay the tax in installments spread over 8 years, subject to “acceleration” of all remaining installment payments in the event of certain “acceleration events” such as the liquidation or sale of substantially all the assets of the taxpayer, or a failure to timely make an installment payment.
Because the TCJA was passed on December 22, 2017, shortly before the filing due date for year-end taxpayers, many taxpayers were faced with the difficult task of computing the post-1986 earnings and profits (E&P) allocated to U.S. shareholders through complex calculations in a relatively short time frame. Further, as a result of the late enactment date of the TCJA, the Service was required to revise tax forms, issue guidance, and update its systems to be able to process Section 965 inclusions in time for the 2018 filing season. Beginning in March 2018, the Service began issuing guidance on the mechanics for computing the transition tax, reporting the transition tax, and remitting payment. Proposed regulations were issued in August 2018 and the final regulations were issued in February 2019. The piecemeal guidance along with timing of the TCJA has made the computation of the Section 965 transition tax even more challenging.
In April 2018, in an effort to make taxpayers aware of the Section 965 transition tax, the IRS’s LB&I division engaged in an outreach campaign to leverage the networks of trade groups, tax advisors, and other stakeholders. The published communication provided a high-level overview of Section 965, identified key action steps for U.S. shareholders of one or more CFCs to undertake, informed taxpayers that they must keep “adequate records” to support the calculation of tax, and made taxpayers aware that the “IRS plans to monitor compliance with the provisions of section 965” and that “[f]ollow-up inquiries may occur if the IRS determines that the required filings and/or payments are not made.” On July 2, 2018 the IRS officially identified the Section 965 Transition Tax as an LB&I Campaign.
Originally rolled-out by the Service in January 2017, campaigns represent a shift away from a return-based approach to tax enforcement to an issue-based approach. The goal of campaigns is to improve return selection for examination, identify issues that represent a risk for non-compliance, and make the most of the IRS’s limited resources. For each identified campaign, LB&I will identify an appropriate action to address the specific compliance risk – this action is labeled a treatment. Treatments range from industry outreach, issuing guidance and passing legislation, the issuance of soft notices, and issued-focused examinations.
While not explicitly spelled out in the IRS announcement, the treatment stream for the Section 965 campaign appears to be industry outreach and issuing guidance to ensure that taxpayers are aware of their filing and payment obligations under Section 965. In the July 2 announcement of the Campaign, the Service simply provided a four sentence overview of Section 965 and provided a link to its prior April 2018 communication.
While there has been relatively little activity surrounding several of the other campaigns, it is unclear what steps, if any, the Service will take to ensure compliance with Section 965 beyond educating taxpayers of their compliance obligations. However, the IRS does require taxpayers that are subject to section 965 to file a Form 965 with their 2018 return that will include substantial reporting of information about the calculation of the section 965 liability for both 2017 and 2018. Because the first returns reporting Section 965 transition tax were recently filed, it is too early to identify specific issues or enforcement initiatives related to the Section 965 calculation. Taxpayers can, however, be prepared for a potential examination of the issue by ensuring that they have adequate records and support for:
- The calculation of the E&P for each CFC and specified foreign corporation, including an explanation for any material audit adjustments made to E&P or the tax pool of the entity;
- The amounts being taxed as cash equivalents and the amounts being taxed as earnings in excess of cash;
- The allocation of E&P deficit amongst the E&P pools;
- The reconciliation of E&P carryforward balances that do not tie to the prior year-end Form 5471 balance;
- The FX rates used; and
- The calculation for the reduced foreign-tax credit and gross-up amount.
Although the recently enacted Section 965 is very different in its approach to taxing un-repatriated foreign earnings than the prior version of Section 965, it is worth noting that the old Section 965 was the subject of dispute between taxpayers and the Service, including Tax Court litigation. Given the potential amounts at stake and the complexity of the calculation it is not unreasonable to believe that the newly enacted Section 965 may likewise give rise to disputes with the Service about the proper calculation of the Section 965 inclusion amount.
For questions on this issue, please contact Justin Donatello at 212-872-3325.