The Tax Cuts and Jobs Act (TCJA) introduced significant changes to the U.S. system of taxation for taxpayers with foreign operations. The TCJA moved the United States from a worldwide tax system to a modified territorial tax system and; as part of the transition, the TCJA includes a one-time tax on accumulated, untaxed earnings of certain specified foreign corporations. The transition tax results in the inclusion of a taxpayer’s pro rata share of the untaxed income of their foreign corporations on their 2017 tax return.
Corporate and individual taxpayers can elect to pay the tax over an eight-year period, with the first payment due with the taxpayer’s 2017 tax return. Taxpayers pay 8 percent of the tax in each of the first five years, 15 percent in the sixth year, 20 percent in seventh year, and 25 percent in the eighth year. Shareholders of S-corporations may elect to defer the tax until one of several triggering events occur that requires the tax to be paid. Taxpayers that owe tax will be required to make the first payment by April 15, 2018.
Corporate and individual taxpayers can elect to pay the tax over an eight-year period, with the first payment due with the taxpayer’s 2017 tax return.
U.S. taxpayers with ownership in a foreign corporation will need to assess a few items to determine whether they are subject to the new transition tax:
“Specified foreign corporations” considered for transition tax
Only “specified foreign corporations” are considered in determining the foreign corporations to include for the transition tax. A specified foreign corporation (SFC) is a foreign corporation that is a controlled foreign corporation or a foreign corporation that has at least one domestic corporate U.S. shareholder. Foreign corporations that have no U.S. corporate shareholders, are not controlled foreign corporations, and have only U.S. individuals with insufficient ownership are generally able to avoid the transition tax. The transition tax only applies to earnings from years in which the taxpayer is considered a U.S. shareholder of an SFC.
While taxpayers may just focus on their personal ownership, the rules may require a taxpayer to attribute ownership from other foreign shareholders depending on the taxpayer’s relationship with the different shareholders of the foreign corporation. Generally, the transition tax rules look at whether a U.S. taxpayer has a 10 percent or greater ownership in a foreign corporation. If so, the taxpayer is considered a U.S. shareholder for the transition tax.
Additionally, the TCJA changed the rules around who is considered a related party for purposes of determining a taxpayer’s effective ownership in a foreign corporation. Prior to the enactment of the TCJA, ownership by related foreign persons (individuals and companies) was not attributed to U.S. shareholders. The TCJA changed this rule to include ownership from related foreign persons. Thus, a U.S. taxpayer’s minority ownership could be stepped up to or above the 10 percent threshold for purposes of determining whether they are subject to the transition tax if they have a foreign related party in the ownership structure.
Earnings and profits of the foreign corporation
U.S. tax rules require that taxpayers calculate the earnings and profits of their foreign corporations using U.S. tax rules. While it may appear from looking at the financial statements that there are no past positive earnings, a calculation of earnings under U.S. tax rules may result in a different outcome. Many taxpayers will need to perform a detailed study of the earnings and profits of their foreign corporations since 1987. If a foreign corporation has positive earnings and profits under U.S. tax rules, the earnings from the foreign corporation could be subject to the transition tax.
Many taxpayers will need to perform a detailed study of the earnings and profits of their foreign corporations since 1987.
Additionally, the TCJA requires that taxpayers measure earnings profits at two dates: Nov. 2, 2017 and Dec. 31, 2017. Thus, taxpayers will need to calculate earnings and profits as of both dates. Whichever date results in the higher earnings and profits, that amount is used towards the transition tax calculation. Note that the IRS has considered that taxpayers may have difficulty getting information together as of Nov. 2, 2017. The IRS is allowing taxpayers to use information as of Oct. 31, 2017 and to adjust to the November 2 equivalent.
The TCJA requires that taxpayers measure earnings profits at two dates: November 2, 2017 and December 31, 2017.
Once a taxpayer has determined the earnings and profits at each of their foreign corporations, the taxpayer must look at whether any of the foreign corporations are in an accumulated earnings and profits deficit position (i.e. accumulated earnings and profits less than zero) as of Nov. 2, 2017. Deficits are allowed to offset and reduce the overall inclusion of earnings for the transition tax.
Transition tax calculation
The calculation of the tax is done by allocating the total earnings and profits between two categories: cash assets and all other assets. Taxpayers must perform a calculation of their “aggregate foreign cash position” between among all their foreign corporations (see below for further detail of this calculation). The taxpayer’s accumulated earnings and profits up to the amount of aggregate foreign cash is taxed at a 15.5 percent rate. The residual amount of accumulated earnings and profits over the amount of aggregate foreign cash is taxed at an 8 percent rate. The resulting transition tax liability may be reduced by foreign tax credits for C corporation taxpayers and certain individuals who make an election to be taxed as a C-corporation. For Individuals, the tax rate for cash equivalents is 17.5 percent and all other assets is 9.1 percent for 2017, this amount increases if individuals have foreign corporations with fiscal year ends in 2018.
A U.S. shareholder’s “aggregate foreign cash position” is the greater of:
- The aggregate of its pro rata share of its foreign corporate cash position as of the close of their last tax year beginning before Jan. 1, 2018; or
- One-half of the aggregate of its pro rata share of its foreign corporate cash positions as of the close of their last two tax years ending before Nov. 2, 2017.
A foreign corporation’s total cash position generally is the sum of its cash, net accounts receivable, and fair market value of certain other liquid assets, including actively traded personal property, commercial paper, certificates of deposit, government securities, short-term obligations, and foreign currency.
The IRS has indicated it will continue to release guidance to provide additional clarifications and eventually issue regulations. At this time, the IRS has not released guidance on how the transition tax will be reported in tax returns.
State tax considerations
For state tax purposes, consideration should be given as to the treatment of the transition tax income inclusion in each state. Some states allow the transition tax inclusion to be excluded from state gross income. Additionally, who ultimately pays the tax matters. The exclusion from gross income is generally only allowed for corporate taxpayers and not individuals. Thus, in a flow-through structure, different state transition tax inclusions can result for different types of partners. In addition, the payment deferral elections aren’t available for state purposes, and 100 percent of the tax would be in the 2017 tax return.
If there is a foreign corporation in your tax structure, consult with your tax advisor on how transition tax will impact your federal and state tax liability for 2017.
The calculation of transition tax is complicated, and gathering the required historical information may be time-consuming, so it is highly recommended to get the process is started.
Consider opportunities to reduce the transition tax by taking advantage of accounting method changes, deficit foreign corporations and foreign tax credits.